How to assess the risk in your investment portfolio

How to assess the risk in your investment portfolio

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

In general, the greater the potential returns on your investment, the more likely it is to fall sharply in value. If you want to maximize the return on your portfolio, ask yourself: what would a big drop in my investments do to me?

The question requires a multifaceted answer – one that examines how a decline in your portfolio would materially affect your finances and how you react emotionally to a loss of money.

Many investors have recently been able to answer this question first-hand. The broad stock market fell almost 24% between January and mid-June, and many individual stocks and more volatile assets like cryptocurrencies fared far worse.

If recent market volatility has hurt a little more than you thought, it’s time to take a moment to introspect, says Christine Benz, Morningstar’s director of personal finance and retirement planning.

“A lot of people got into the market in 2020 and 2021 just because it was up,” Benz tells CNBC Make It. “Now is a good time to take a deep breath, step back and think about the risk you have in your portfolio.” should be dealt with appropriately.”

According to market experts, this is how you ensure that you invest with the right level of risk.

Understand risk capacity and risk tolerance

Back to the central question: What would a sharp drop in the value of your portfolio do to you?

First, a decline in your portfolio would significantly impact the rest of your financial picture. This is called your risk capacity. When you’re years away from a long-term goal like retirement, short-term dips in your portfolio aren’t necessarily a big deal since your investments need decades to recover.

However, if your goal is in the near future, a big loss could thwart your plans. For example, if you earmarked a portion of your portfolio for a down payment on a house this year, you might not be able to afford a 24% drop.

Second, how would you feel if you lost a large amount on your portfolio? The answer is bad, of course—but how bad? “Checking your brokerage account grimly every morning” bad or “panic selling every investment you own” bad?

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

“Who doesn’t panic? When you go down on a roller coaster and your stomach turns, that’s normal,” he says. The problem arises when “you feel like jumping off the ride or never riding a roller coaster again.”

How to take the appropriate risk

If the recent fluctuations in the market haven’t affected your financial plans, your only next step is to stay the course. But if you’ve strayed from your plans or had no plan at all, it’s time to get your portfolio on track.

Start with your risk capacity, Benz suggests: “Think about what you want to achieve and how close you are to when you need the money. You may need sub-portfolios for different goals.”

In general, younger people who are saving for retirement can invest most of that part of their portfolio in a broadly diversified range of stocks, says Benz. They offer higher returns than other types of assets over the long term, but they also tend to carry higher risk.

For short- or medium-term goals that are one to three years ahead, “consider adding safer assets like cash, short-term bond funds, and US Treasury funds,” says Benz. From there, she adds, consider how you’ll respond to losses in the future: “Risk-ability doesn’t matter if you turn your well-conceived plan on its head if you’re dealing with the losses you’ve suffered in the short-term.” , feel uncomfortable term.”

Many online questionnaires can help you determine your risk tolerance. Examining your behavior during recent downdrafts can be an equally useful benchmark, experts say.

“If I don’t feel comfortable in such an up-and-down market, I have to think about that and take protective measures so next time I don’t feel that way,” said Kelly LaVigne, vice president of consumer insights at Allianz Leben. “Because it will happen again. And you will feel bad again.”

To avoid the kind of panic you may have felt during the first half of the year, consider reducing your allocations to riskier assets like stocks and cryptocurrencies. You may also consider investing in a fund that manages the allocations for you.

“An all-in-one fund, like a target date fund, can help take you out of the equation and let the product do the heavy lifting,” says Benz.

A financial advisor can help on this front as well, Levine says: “The most important thing is to make sure you don’t follow your gut instinct and back out of the market until you’ve spoken to someone who can help you with your allocation.” “

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