How to Think About Investment Risk
After the volatility we've seen from the market during the past five to six years, there are some gun-shy investors out there. Does the possibility of some risk make you want to run for the hills?
Investing risk isn't a terrible thing. In fact, risk is an inherent part of investing.
The definition of risk, as it pertains to investing, is the possibility you may lose part or all of your investment in exchange for the possibility that you may profit. But it's not quite that simple because, in many cases, investments that sustain losses can rebound.
Volatility--the ups and downs of your investments--is an element of risk. For retirement investors, who should be investing with a long-term outlook, volatility is the primary measure of risk.
As a general rule, potential investing returns become larger as risk increases. And, as risk decreases, potential returns become smaller. Translation: If you're willing to take more risk, you may see larger gains. If you stick to lower-risk investments, you'll have a lower potential profit.
So when is it OK to take more risk, and when do you want to tone it down?
If you have a longer retirement investing timeline--meaning you won't need to access your retirement savings for decades--there is an opportunity to add more aggressive investment options to your portfolio. With a long retirement timeline, if you take a risk and lose some money, you have decades to recoup the loss. Conversely, a shorter timeline may call for a more conservative portfolio because you lack the time to recover losses.
Consider, also, your general investing timeline. Hypothetically, you may plan to retire in 15 years, at age 65. That's your retirement timeline. But you need money until the time of your or your partner's death. Your investing timeline will continue long after your retirement timeline terminates. At retirement, you'll probably adjust your investing strategy to reduce risk. But that won't eliminate all risk because you'll still need to continue to grow investments after retirement in order to fund living expenses. And then there's risk tolerance. Your tolerance for risk should be fairly static because it's part of your personality. People who are comfortable taking risk in other parts of life will, similarly, be more at ease taking investing risks.
Experiencing an investing loss often alters a person's risk tolerance. So think about how you'd feel if market volatility increased and your account balance saw some ups and downs. If the thought makes your stomach turn, you're not cut out for a very aggressive allocation because aggressive investors are willing to take on more risks, and they can handle portfolio volatility. Conservative investors aren't willing to take investing risks, and they don't like volatility.
Resist the urge to adopt an inappropriately risky portfolio in a bull market. Your portfolio should already be set up to account for market and economic trends. Don't pile on the risk to increase your returns if you know you'll panic if the risks lead to losses.
The bottom line is that you, as an investor, should use risk to your advantage. Don't be turned off by the idea of risk--just take on the appropriate amount for your personal situation.
Scott Holsopple is the president and CEO of Smart401k, offering easy-to-use, cost-effective 401(k) advice and solutions for the everyday investor. His advice has been featured on various news outlets, including FOX Business, USA Today and The Wall Street Journal.
Nothing in this article should be construed as a guarantee that your 401(k) investments will be profitable. The performance of any individual's 401(k) investments will vary based upon a variety of factors, including, but not limited to, economic and market conditions during any particular period of time as well as performance of the individual funds available in any particular plan. 401(k) plan investments may lose value.
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