This is part two of our series “How to Invest in a Volatile Market.” Check out part one on creating a financial roadmap here.
No matter what life stage you are in, investing successfully requires an evaluation of your risk tolerance. The more time you have for your money to grow (a.k.a., the younger you are), the more risk you can afford to take. On the other hand, if you are nearing retirement, safer investments are better because you won’t have time to make up any losses the market doles out.
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However, there is much more to evaluating your tolerance for risk than simply looking at your age, which is only one factor. You should also consider your goals and the timeframes you have set for them and other factors.
Understanding risk
The Financial Industry Regulatory Authority (FINRA) offers a primer on investment risk here. It's important to realize that all investments consider some risk. While bank and credit union deposits are usually insured by the Federal Deposit Insurance Corporation (FDIC), not all accounts are protected from risk.
For example, certificates of deposit (CDs) issued by banks or credit unions carry with them inflation risk. There is always a chance that inflation will outpace the interest earned by the CD, so even though the dollar balance grows until it matures, inflation may increase faster, meaning that the amount of money you have at maturity won't be able to pay for as much as it could have when you originally deposited the money.
Other risks include market risk, which basically just means that the value of the investment falls due to market conditions. Business risk is based on company- or industry-specific decisions like mergers or new government regulations. Liquidity risk occurs when it becomes difficult to cash out your investment. Concentration risk is a concern if you don't adequately diversify your portfolio.
In many cases, the riskier an investment is, the greater the reward will be if it pays off. However, often that's a major if.
What to evaluate when determining risk tolerance
During times of market volatility, it becomes even more important to pay attention to your risk tolerance because investing in general becomes riskier than during times when the market is flying up, up and away. Among the factors you should consider when determining your risk tolerance are the amount of time you have to invest before your goal must be met and the amount of money you can afford to lose or, at the very least, not have access to for a while.
During times of low volatility, it can be very difficult to truly understand what your risk tolerance is because all or most of your investments have been gaining money in the short term. However, if you are emotionally and logically (based on fundamental, quantitative factors) able to stay in an investment even after the market turns into a downward trajectory, then you will start to see what your tolerance really looks like.
The bull market has lasted for over 10 years, so gauging what your risk tolerance looked like before it began is only a small part of the picture. You're now 10 years older, 10 years closer to or into retirement, and 10 years closer to or now in one of your short-term goals. Thus, it's a good idea to take some risk tolerance surveys to get a better idea of what to do now when the market becomes more volatile. You may want to consider taking more than one survey and then comparing the results.
Vanguard, Morningstar and Schwab have some excellent resources and surveys to help you assess your risk tolerance. The University of Missouri's Department of Financial Planning and Rutgers University also have assessment surveys that can help you figure things out. If you already work with a financial planner or advisor, you should also take any surveys or assessments they have available and compare the results with those from one or two other surveys.
Once you have an idea about how much risk you can tolerate when the market becomes volatile, you can set about selecting an assortment of investments. Risk also plays a role in the selection process, so watch for part three of this series, which will focus on selection based on your risk tolerance. For now, check out how Warren Buffett manages risk here.
This article first appeared on ValueWalk Premium
