Money
Before Investing in the Stock Market...
Evaluate Your Risk Tolerance
October 2018
By Nancy Burger
If you follow financial news and you're not currently invested in the stock market, you might be asking yourself why. There's a lot of chatter about the nearly nine-year-old bull market (a market in which stock prices are rising) and all the money that's being made in certain sectors, particularly technology (think Apple).
But even though the stock market has been steadily gaining for years, that doesn't mean there aren't hiccups - periods when the market drops, sometimes by a considerable amount. So, before you consider investing in stocks, it's important that you take a hard look at your risk profile - that is, how much share price fluctuation you can stomach on any given day.
This can be a trickier exercise than you might think. While you might consider yourself an aggressive, thrill-seeking investor, your reaction to losing money may reflect a different reality. To better understand your risk tolerance, consider your behavioral tendencies, such as what actions you’d likely take after experiencing a significant investment loss. Are you prone to emotional reactions when it comes to money? When it comes to stocks, this can lead to costly decisions.
In fact, behavioral scientists say that the fear of loss can play a bigger role in human decision-making than the anticipation of gains - which means you may not be fully aware of your appetite for risk until you're faced with a potentially significant loss. For example, you might convince yourself that purchasing shares of a "hot" new stock is worth the potential risk because of what seems a huge upside potential. But hot stocks can suffer from considerable volatility, so be mindful of how you would react if the share price were to suddenly plunge. Would you knee-jerk to selling all the shares (therefore solidifying your losses), or would you weather the storm? Being honest with yourself is the best way to build a portfolio that you’ll stick with, especially when the market takes a turn.
One way to evaluate your risk tolerance it to consider the maximum drawdown of a portfolio in terms of dollar value, not percentage. For instance, you might think you could stomach a 40% decline, but if you have a portfolio of say $750,000 and 40% translates into a loss of $300,000, you might gauge the level of risk differently.
When assessing risk tolerance, it's also important to have a firm understanding of your financial goals - specifically, when you'll be needing the money you're investing. If, for example, you plan to sell a portion of your stocks to fund the purchase of a home five to seven years down the road, you might be more willing to endure price fluctuations than you would if you'll be needing the money to purchase a car in six months.
Risk tolerance is also tied to your unique financial situation, how much debt or other obligations you might be facing. If you have a mortgage, your own business, kids approaching college or elderly parents who depend on you financially, you may be less able to deal with market ups and downs than if you're single and debt-free.
Gauging your own risk appetite is an important step in creating an investment portfolio that best reflects - and can help you reach - your personal financial goals.
But even though the stock market has been steadily gaining for years, that doesn't mean there aren't hiccups - periods when the market drops, sometimes by a considerable amount. So, before you consider investing in stocks, it's important that you take a hard look at your risk profile - that is, how much share price fluctuation you can stomach on any given day.
This can be a trickier exercise than you might think. While you might consider yourself an aggressive, thrill-seeking investor, your reaction to losing money may reflect a different reality. To better understand your risk tolerance, consider your behavioral tendencies, such as what actions you’d likely take after experiencing a significant investment loss. Are you prone to emotional reactions when it comes to money? When it comes to stocks, this can lead to costly decisions.
In fact, behavioral scientists say that the fear of loss can play a bigger role in human decision-making than the anticipation of gains - which means you may not be fully aware of your appetite for risk until you're faced with a potentially significant loss. For example, you might convince yourself that purchasing shares of a "hot" new stock is worth the potential risk because of what seems a huge upside potential. But hot stocks can suffer from considerable volatility, so be mindful of how you would react if the share price were to suddenly plunge. Would you knee-jerk to selling all the shares (therefore solidifying your losses), or would you weather the storm? Being honest with yourself is the best way to build a portfolio that you’ll stick with, especially when the market takes a turn.
One way to evaluate your risk tolerance it to consider the maximum drawdown of a portfolio in terms of dollar value, not percentage. For instance, you might think you could stomach a 40% decline, but if you have a portfolio of say $750,000 and 40% translates into a loss of $300,000, you might gauge the level of risk differently.
When assessing risk tolerance, it's also important to have a firm understanding of your financial goals - specifically, when you'll be needing the money you're investing. If, for example, you plan to sell a portion of your stocks to fund the purchase of a home five to seven years down the road, you might be more willing to endure price fluctuations than you would if you'll be needing the money to purchase a car in six months.
Risk tolerance is also tied to your unique financial situation, how much debt or other obligations you might be facing. If you have a mortgage, your own business, kids approaching college or elderly parents who depend on you financially, you may be less able to deal with market ups and downs than if you're single and debt-free.
Gauging your own risk appetite is an important step in creating an investment portfolio that best reflects - and can help you reach - your personal financial goals.
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Co-founder Nancy Burger started her finance career on Wall Street in the 1980’s and now works as a freelance analyst and writer for a money management firm. She has contributed to articles that have appeared in Forbes.com, Nasdaq.com, TheStreet.com and CNBC.com.
