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How are you handling risk?
The crisis in Ukraine, the Fed battling our inflationary environment ... . These ongoing emotional market headlines provide plenty of “reasons” for increased market volatility over the past few months.
And when it feels like our world is spinning out of control, it’s tempting to panic, especially when it comes to our finances. After all, human beings are naturally averse to loss, and the pain of losing is more powerful than the potential to achieve gains.
The challenge: When we make emotional decisions and act irrationally in an attempt to avoid loss, we can lose even more. Just ask any investor who has sold stock when the market dropped and missed the recovery, only buying back in when the markets were high again.
What’s the solution? We know we need to invest to grow our money into a nest egg that will sustain us in the future, but how do you see that you don’t take on too much risk in the process?
What is risk?
In the financial world, risk tolerance is defined as a measure of one’s financial ability to withstand permanent losses. While you can’t completely eliminate risk in your portfolio, you can see the amount of risk you take correlates with the level of potential reward for you to gain.
It is more than possible to match your investments to your goals while still being able to sleep at night during market downturns.
Here’s the thing we need to remember when we’re tempted to get out of the market ASAP: Some risks are avoidable, some are not.
Avoidable risks are those that occur when your portfolio leans too heavily on stocks or bonds that have been unstable in the past or when your holdings are not diversified appropriately.
For example, you may be putting too much of your company’s stock in your 401(k) plan. Or you may have an overabundance of overlapping U.S. stock mutual funds instead of being more globally diversified.
Avoidable risks often occur when we underestimate risk and believe we can tolerate more than we actually can.
On the other hand, unavoidable risks are those that occur because our world is ever-changing and volatile, and we can’t predict everything. As much as we wish they weren’t, unavoidable risks are simply out of our control. This type of risk includes unfortunate events such as geopolitical issues and pandemics.
The third category of risk is often unseen, but it can impact your portfolio just as intensely as an obvious risk — the risk of being too conservative and not achieving your future goals as a result.
By overestimating risk and trying to avoid loss at any cost, you could be unintentionally sacrificing your future dreams.
What do I do about risk?
Unfortunately, it’s not as simple as telling your adviser you feel comfortable with “moderate” risk. Everyone has their own risk tolerance level, based on their age, life circumstances and time horizon.
It’s important to run through various scenarios with different risk levels to get an idea of how much loss you are comfortable with. If you start to panic and cringe, then you know you have hit or passed your limit.
Both positive and negative emotions frequently cause investors to make unwise decisions. If you’re excited about the upward swing of the market, you might throw caution to the wind and invest more money than you normally would.
On the flip side, fear might drive you to react and sell if you start losing money.
A prudent method to identify your risk tolerance and how it may affect your financial future is using an interactive planning tool. This will allow you to create a plan that identifies your fears, goals and expectations and is able to run a variety of “Stress Test” scenarios.
This will provide you with a score/grade that illustrates the future impact of specific decisions you make today.
Other factors such as “What are you afraid of?,” future health care costs, low returns, inflation — along with any possible changes in income — can be quantified and will provide information for your strategies.
By creating an interactive plan that measures your risk tolerance, you can simulate situations that cause emotional responses so you are prepared when they happen in real time.
It’s a safeguard that will help keep you focused on the long term and trust in your strategy.
This article is provided by Pete Alepra, a financial adviser at RBC Wealth Management in Cedar Rapids; [email protected]. The opinions in this article are for general information only and are not intended to provide specific advice or recommendations for any individual.
RBC Wealth Management is a division of RBC Capital Markets, a member NYSE, FINRA and SIPC. RBC Wealth Management does not provide tax or legal advice. All decisions regarding the tax or legal implications of your investments should be made in consultation with your independent tax or legal adviser.
Due diligence and diversification do not assure a profit or protect against loss. Investing involves risks, including possible loss of principal.
Pete Alepra
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