How to assess risk in your investment portfolio

How to assess risk in your investment portfolio

There are millions of different investments you can buy, and they all require you to consider the same key trade-off: risk versus return.

Generally speaking, the greater the potential return on your investment, the more likely it is to plummet in value. When looking to maximize your portfolio returns, ask yourself: What would a big drop in my investments do for me?

The question requires a multifaceted answer—one that examines both how a fall in your portfolio would significantly affect your finances and how you react emotionally to losing money.

Many investors have been able to answer this question firsthand recently. The broad stock market fell nearly 24% between January and mid-June, and many individual stocks and more volatile assets such as cryptocurrencies fared much worse.

If the recent market volatility has hurt a little more than you thought, consider taking some time for introspection, says Christine Benz, director of personal finance and retirement planning at Morningstar.

“A lot of people got into the market in 2020 and 2021 just because it was going up,” Benz told CNBC Make It. “Now is a good time to take a deep breath, step back and think about what is the appropriate amount of risk to take on in your portfolio.”

Here’s how to make sure you’re investing with the right level of risk, according to market experts.

Understanding risk capacity and risk tolerance

Back to the main question: What would a big drop in the value of your portfolio do for you?

First, a drop in your portfolio would materially affect the rest of your financial picture. This is called your risk capacity. If you’re years away from a long-term goal, such as retirement, short-term dips in your portfolio aren’t necessarily a big deal because your investments have decades to recover.

However, if your goal is in the near future, a big loss can derail your plans. If you had part of your portfolio earmarked for a down payment on a house this year, for example, you may not be able to afford a 24% drop.

Second, how would a big loss make you feel in your wallet? The answer is, of course, bad – but how bad? “Gloomily checking your brokerage account every morning” bad or “selling every investment you own in a complete panic” bad?

Investing professionals call your ability to stick to your financial plan in the face of investment losses your risk tolerance. It’s okay to panic when the big red numbers start filling your portfolio page, says Brad Klontz, a certified financial planner and professor of financial psychology at Creighton University. But if you let that panic push you into rash financial decisions, you could potentially do real damage to your finances, Klontz says.

“Who doesn’t panic? If you’re on a roller coaster going down and your stomach turns, that’s normal,” he says. The problem arises when it “makes you want to jump off the ride or never ride a roller coaster again.”

How to take the right amount of risk

If the recent market volatility hasn’t affected your financial plans, then your only next steps are to stay the course. But if you’ve strayed from your plans or never had a plan in the first place, it’s time to get your portfolio on track.

Start with your risk capacity, suggests Benz: “Consider what you’re trying to achieve and your proximity to when you need the money. You may find that you need sub-portfolios for different purposes.”

In general, younger people saving for retirement can invest that portion of their portfolio primarily in a broadly diversified set of stocks, Benz says. They offer higher long-term returns than other types of assets, but they also tend to come with more risk.

For short- or medium-term goals, which are one to three years, “consider adding safer assets like cash, short-term bond funds and U.S. Treasury funds,” Benz says. From there, she adds, think about how you’ll react to losses in the future: “Risk capacity doesn’t matter if you’re going to change your well-laid plan when you’re uncomfortable with the losses you’ve incurred in the short term.”

Plenty of online questionnaires can help you determine your risk tolerance. Examining your behavior during the recent downtrend can be an equally useful yardstick, experts say.

“If I don’t feel comfortable in that kind of bull market, I have to remember that and put in place protections so I don’t feel that way the next time it happens,” says Kelly Lavin, vice president of consumer insights at Allianz Life. “Because it’s going to happen again. And you’re going to feel bad again.”

To avoid the panic you may have experienced in the first half of the year, consider reducing your allocations to riskier assets such as stocks and cryptocurrency. You may also consider investing in a fund that manages distributions for you.

“An all-in-one fund, such as a target date fund, can help you remove yourself from the equation and let the product do the heavy lifting,” Benz says.

A financial advisor may be able to help on that front as well, says Levine: “The most important thing is to make sure you don’t follow your instincts and pull out of the market until you talk to someone who can help you with the allocation. “

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