- Risk tolerance is generally how well you can stomach volatility in the value of your investments.
- This aspect of investing is important, because it can cause you to make poor decisions if your portfolio does not reflect your ability to withstand market turmoil.
- Part of the equation is the length of time until you need the money you have invested.
If you find yourself breathing a sigh of relief when the stock market inches upward and fear it going down again, you might want to evaluate your risk tolerance.
In simple terms, this is how well you can stomach volatility in the value of your portfolio. It matters, because it also can be at the root of problematic investment decisions.
"If someone is biting their nails during the current market swings, then they need to reassess whether they are invested too aggressively for their personal situation and views on risk," said Ryan Fuchs, a certified financial planner with Ifrah Financial Services in Frisco, Texas.
So far in 2018, volatility largely has ruled the stock market. After peaking on Jan. 26, the major stock indexes zigzagged their way downward before recently ticking up.
Year to date, the is up 0.58 percent as of April 19 and and the Dow Jones industrial average is down 0.37 percent.
However, the long-running bull market means retirement savers largely have watched the value of their nest egg climb upward for nine years with infrequent corrections and low volatility. For instance, since March 2009 — when stocks began moving upward after the financial crisis — the S&P has returned over 260 percent despite the recent pullback.
While no one can predict with certainty whether lower stock prices will be short-lived or when a bear market will emerge, the current volatility is likely to test the wherewithal of some investors.
Many financial advisors talk about risk tolerance as a function of your emotional response to swings in the market and how long until you need the money.
This can be troublesome if there is a mismatch.
"Taking on more risk than you're comfortable with could cause you to panic and sell at the wrong time," said Jim Shagawat, a certified financial planner, and president of Windfall Wealth Advisors in Paramus, New Jersey.
"Taking on too little risk could lead to lower returns than you had hoped for," Shagawat said.
For instance, if you are a young retirement saver and have all your money in safer investments because you're afraid of stocks, you run the risk of your return barely beating inflation over decades.
This is when a little education can be helpful.
Eric Roberge, a certified financial planner, recently showed a new, 30-year-old client how a portfolio she was considering would have performed during the 17-month bear market that lasted from October, 2007 to March, 2009, when the S&P lost 56.8 percent. The particular mix of stocks and bonds the client was considering would have lost 17 percent.
"It's not all in or all out of stocks," said Roberge, founder of Beyond Your Hammock in Boston. "When people realize that, it's amazing how much more comfortable they are."
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He also makes sure his younger retirement-saving clients understand it's unrealistic to expect markets to consistently go nowhere but up.
"The conversation is that we're looking at the long-term, and I show them the type of growth we can expect," Roberge said. "I also explain that we can expect extreme ups and downs in the market before then."
Meanwhile, if you are nearing retirement or already there, your portfolio likely is more insulated from stock price swings, especially if you are pulling income from it. Nevertheless, if market downturns weigh heavily on you, it's time to consider adjusting your exposure to stocks and, therefore, the amount of risk you're taking on.
"If volatility has you on edge, you need to go back and re-address what your goals are, what your timeline is for those goals and whether or not your investments are structured with that in mind," said Ed Snyder, a certified financial planner and co-founder of Oaktree Financial Advisors in Carmel, Indiana.
Even if you tend to deal stoically with volatility, make sure you consider the goal of the money invested in stocks. For instance, if you need it soon for, say, a big vacation, and it's all in stocks, you run the risk of its value dropping if the market heads lower.
Generally speaking, it's easier to know what to do — or not do — during market zigzagging if you already have a financial plan in place that you can revisit.
"Make your investment decisions when you're not experiencing extreme emotions," said Roberge at Beyond Your Hammock. "Write down your plan and how you'll react if there's a drop. You can go back to that written advice you gave yourself to remind yourself what you should be doing."