Dollars & Sense

3 Factors to Determine How Much Risk Is Right for You

As you discuss your goals with your financial advisor, you can determine the risks and trade-offs you may need to achieve them.
Kate Warne, March 2018

Risk is a normal part of investing — in fact, some risk serves a valuable purpose. If you didn’t accept some risk while investing, there wouldn’t be the potential to achieve higher returns. But it’s also important to ensure the amount of risk is appropriate based upon what you’re trying to accomplish. Here are 3 important areas to consider when assessing risk:

• Risk Tolerance: Gauging risk tolerance (or your comfort with risk) and your potential behavior is important because it’s unlikely you’ll reach your long-term goals if you abandon your strategy during the inevitable market decline. Typically, you’ll be asked to complete a questionnaire that can gauge how you might react to risk in different situations.

• Risk Capacity: Risk capacity considers your ability to handle risk, and your investment time horizon is often one of the biggest determining factors. If you’re younger and preparing for retirement, you have a long time to make up for potential declines and could reasonably handle more volatility. However, if you’re retired, your ability to handle stock market declines is likely smaller.

• Required Risk: What level of risk is required to achieve your investment goals? The higher the return you need to reach your goals, the more potential risk you must take to achieve them, or other trade-offs (investing more, working longer, etc.) may need to be made. As you discuss your goals with your financial advisor, you can determine the risk/return and other trade-offs you may need to achieve them.

Typically, what prevents most investors from reaching their goals is not market volatility itself, but their reaction to it. Understanding your comfort level with risk can help you avoid some emotional investing mistakes, such as chasing performance. By knowing your risk tolerance in advance, you can better stick to your long-term strategy during inevitable market corrections along the way.

So how much risk makes sense for your situation? Ultimately, it’s the balance between how much risk you’re comfortable with taking with the amount you need to take to reach your goals. As you work to balance these items, you may need to make some difficult decisions to create an appropriate investment strategy that fits your needs.

Kate Warne, PhD, is an investment strategist at Edward Jones.


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