Many market shocks are short lived once investors conclude the event is unlikely to cause lasting economic damage.
Still, major market downturns such as the 2000 dot-com bust and the 2008-09 credit crisis are powerful reminders that we cannot control or predict exactly how, where or when precarious economic situations will arise.
Market risk refers to the possibility that an investment will lose value because of a broad decline in the financial markets, which can be the result of economic or sociopolitical factors. Investors who are willing to accept more investment risk may benefit from higher returns in the good times, but they also get hit harder during the bad times. A more conservative portfolio generally means there are fewer highs but also fewer lows.
Your portfolio's risk profile should reflect your ability to endure periods of market volatility, both financially and emotionally. Here are some questions that may help you evaluate your personal relationship with risk.
How much risk can you afford?
Your capacity for risk generally depends on your current financial position (income, assets and expenses) as well as your age, health, future earning potential and time horizon. Your time horizon is the length of time before you expect to tap your investment assets for specific financial goals. The more time you have to keep the money invested, the more likely it is that you can ride out the volatility associated with riskier investments.
An aggressive risk profile may be appropriate if you're investing for a retirement that is many years away. However, investing for a teenager's upcoming college education may call for a conservative approach.
How much risk may be needed to meet your goals?
lf you know how much money you have to invest and can estimate how much you will need in the future, then it's possible to calculate a "required return" (and a corresponding level of risk) for your investments. Older retirees who have sufficient income and assets to cover expenses for the rest of their lives may not need to expose their savings to risk. On the other hand, some risk-averse individuals may need to invest more aggressively with the goal of accumulating enough money for retirement and offset another risk: inflation potentially eroding the purchasing power of their assets over the long term.
How much risk are you comfortable taking?
Some people seem to be born risk takers while others are cautious by nature, but an investor's true psychological risk tolerance can be difficult to assess. Some people who describe their personality one way on a questionnaire may act differently when tested by real events.
Moreover, an investor's attitude toward risk can change over time, with experience and age. New investors may be more fearful of potential losses. Investors who have experienced the cyclical and ever-changing nature of the economy and investment performance may be more comfortable with short-term market swings.
Have a plan
Market declines are an inevitable part of investing, but abandoning a sound investment strategy in the heat of the moment could be detrimental to your portfolio's long-term performance. Having a financial plan in place could help you manage your emotions when turbulent times arrive. Contact a financial advisor at Waddell & Reed to discuss creating a plan for your financial future.
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All investing involves risk, including the possible loss of principal, and there is no guarantee that any investment strategy will be successful.
This information is provided for educational purposes only and may include references to concepts that have legal, accounting and tax implications. It is not to be construed as legal, accounting or tax advice, and is provided as general information to assist in understanding the issues discussed. It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Waddell & Reed does not provide tax or legal advice. Please consult with the appropriate professional regarding your personal situation prior to making any financial related decisions.