Investing in a volatile market can be a scary and intimidating task. There is no doubt that knowing how to mitigate risk is important. However, before you can do that, you need to know your risk tolerance: Is yours aligned with your investment goals?
In this article, we’ll look at some key factors that affect the risk of investing in stocks, including volatility and time horizon. We’ll also talk about proactive vs reactive investing—and how you can use all of these factors together for determining your personal risk tolerance for the future.
This article answers the following questions:
Your risk tolerance is a personal decision. It should be considered in light of factors such as your age, income, and financial goals. For example, if you are young with a long career ahead of you, then it’s probably safe to assume that your risk tolerance will be relatively high for some time.
On the other hand, if you are nearing retirement and you have fewer years left to contribute towards your retirement, then it might make more sense for you to err on the side of caution when deciding how much money should be invested in stocks vs bonds vs cash. Everyone has their own comfort level when it comes to taking risks with their investments because we’re all individuals approaching things from different personal situations.
One person may feel comfortable risking 10% of their portfolio to higher-risk investments while another would rather invest 100%, conservatively, as they prepare for retirement in 5 years’ time. The common denominator here is that everyone needs to understand what kind of investor they want to be: Are you someone who takes calculated risks or someone who prefers stability above all else?
Risk tolerance and risk appetite are often confused as having the same meaning. Regardless, in the financial industry, they refer to two entirely different things:
Getting clear enough concepts in mind to understand the difference between these terms is vital. Otherwise, it gets incredibly tough to verify that you’re making the right decisions for your investment portfolio. The key takeaway here is that risk tolerance and appetite are not interchangeable.
One refers to how much volatility investors are willing to tolerate within their portfolios, while the other relates specifically to their investing goals (such as when they need funds or what type of investments will work best for them). Your risk tolerance can be affected by various market conditions. For example, some investors may be more willing to take on risk if there’s potential for rapid, rising-interest-rate-related gains.
At the same time, if markets are volatile and unpredictable—such as they are right now—others may feel anxiety and become risk-averse. This makes it important to remember that our level of tolerance isn’t always static; it can change over time. As you learn more about investing, and your confidence grows, you may find yourself open to taking on more risk in order to potentially achieve greater returns.
Volatility is a measure of how much the price of an asset fluctuates. The market value of a stock or bond will vary on any given day. As a result, this variation can be measured using metrics, such as its standard deviation, variance, or average true range (ATR). Before we go deeper into the weeds than we should on these, let’s jump to a more essential point.
Believe it or not, to a certain degree, market volatility is often cyclical. This may sound hard to believe given headlines right now, but it is true: The economy and stock markets are much like a weather system. Volatile periods are like storms that blow in, sometimes creating challenges for all around… and then they dissipate or move on.
There are certain factors that can make for an unusually rough, sustained down or volatile cycle—so we’re not saying it’s all 100% cyclical. However, historically, volatility driven by inflation will peak and then (eventually) decline. The Federal Reserve often raises interest rates in response to inflation. This can help cool down an overheated economy, which in turn can help bring more stability to the markets.
Unfortunately, a side effect of the Fed’s interest rate hikes (or increases) is that some assets tend to lose value under those circumstances. Fixed-rate bonds, for instance, typically lose value in relation to each hike. This can cause declines in portfolios of investors whose assets aren’t balanced for market volatility.
Conversely, investors holding an array of assets strategized to make the most of higher rates tend to see gains. Overall, it can come down to a trio of factors:
There is a fourth factor we saved for this section: Your time horizon is the length of time over which you have to invest. This is just as essential to making investment decisions because it increases or decreases your ability to take on risk. That, in turn, can affect your portfolio’s overall volatility.
A soon-to-be retiree, for example, will have a shorter time horizon than a 20-something who has only been working for a few years. Everyone has to review their personal circumstances and decide for themselves. At the same time, try to avoid letting fear hold you back from investing in what could be great businesses over time—if the chief reason why is that short-term losses make you uneasy.
Investing can be intimidating at first, but by figuring out your risk tolerance and planning for volatility, you can make it less so. ViaWealth has wealth management investment solutions for experienced investors, newcomers, and all levels of familiarity. Schedule an appointment today.