The prospect of placing your money into a potentially unpredictable market can be enough to give any investor cold feet, especially one that is just beginning to dip their toes into the investing world. Whether you are a brand-new or more experienced investor, consider how you feel about risk. Perhaps you understand it and know how it can work to your benefit, or maybe you want to avoid it at all costs. Regardless, there are risks in investing, and determining your personal tolerance for risk is an essential part of creating an effective investment plan.
Risk tolerance is the degree of risk an investor is willing to endure to receive returns on his/her investments. Your heuristics, lifestyle, timeline, goals, and even your personality play into how much risk you should assume. As you work closely with your trusted TrueNorth Wealth financial planner in Utah, take these four steps to determine your risk tolerance.
1. Understand What Risk Is And Is Not
Often, people relate investing to gambling. There is no meaningful comparison – like, at all. When you are talking about “risk” with an intelligent financial planner, the focus of the conversation has far more to do with “time and age” than it does anything else. Why? Because the past 50 years of the stock market teach us a lot about “risk” and how markets behave.
Those 50+ years mean something. That amount of time teaches us about risk, cycles, profit margins, diversification, emerging markets, inflation, and on and on. There is some level of “risk” wherever you keep your money. I don’t care if it’s under your mattress or in a bank account; there is risk! Let an educated advisor, a CFP, teach you about risk, how it plays out in your investments, and how we can use volatility to build and secure your wealth.
2. Evaluate Your Timeline
Often, the more time between now and the day you need your money, the more risk you can safely assume in your investment portfolio. So, your first step will be to create a timeline of when you need to use the money you are investing.
As a young professional with decades until retirement, you should feel comfortable taking on a substantial amount of risk. A severe market drop will be fairly easy for you to ride out, and if you stick to your long-term investment plan, you will likely even profit from it. So, if you have a long investment timeline, consider putting your money into higher-risk, higher-reward investments.
On the other hand, if you are planning to retire soon, your risk tolerance should be much lower. A drop in the market could be devastating to your retirement plan. Thus, you should have your money in less volatile investments. This will protect your assets and help you reach your retirement goals.
This also means that, yes, your risk tolerance will likely change throughout the course of your investment career. Determining your risk tolerance is an ongoing process and should be a frequent topic of communication with your financial advisor.
3. Establish Your Investment Goals
What are you investing for, and how much do you want to have saved? Some investments are for necessities like retirement or college, while others may function as extra income. Create a detailed plan of your investment goals so you can determine how much risk you are willing to take on to achieve them.
When investing for necessities, you will want to use methods that assume less risk: think IRAs and 529 plans. Although the reward may not be as impressive, it will be safe and consistent. On the other hand, you can use your “risk capital,” or money set aside specifically for investing, to invest specifically for extra income. When it comes to investing true risk capital, you have more flexibility to take on a higher risk to receive higher rewards.
4. Consider What You Can Psychologically Endure
Reflecting on your own behavioral tendencies is essential. So much of investing is psychological, and so your risk tolerance must be determined by how you will react when it looks like your account value may take a serious hit. When the market drops, are you going to want to pull everything out? Or will you have the mental fortitude to wait out the cycle — perhaps even buy more. Wherever you stand, use that to create an investment plan you can be confident in through any type of market.
Remember, having a trusted financial planner to walk you through these steps is essential — it is valuable! An advisor will help you evaluate your timeline, goals, and any other personal factors. Together, you can use these factors to help you determine your risk tolerance and create an investment plan that you can stand by, whether the market is bear or bull.
Schedule a consultation with the fee-only financial planners at TrueNorth Wealth today to get started.