If you've ever had a meeting with a broker or other financial professional, you've almost certainly seen some variant of the dreaded "risk questionnaire." Most of these questionnaires ask a number of factual questions about your current financial situation, as well as hypothetical questions designed to determine what your response is likely to be when normal price fluctuations occur in the financial markets.
In making any type of financial plan, it is indeed extremely important to understand how much risk you are able to tolerate. In general, when you are trying to invest with particular goals in mind, there are three variables that interact to determine how you can achieve them: how much you have to invest, how much time you have to reach your goals, and how much the return on your investment will be. Because return is generally proportional to risk, the greater the return you are seeking, the more risk you must be willing to take. How these three factors interact will help you determine what types of investments will work best for you.
In fact, you can find a variety of financial calculators on the Internet that attempt to reduce this question to an exact science. "Give us some information about yourself," these calculators claim, "and we will tell you exactly how you should invest." Many such calculators, especially those offered by particular financial companies, are then more than willing to suggest proprietary funds that follow their suggested asset allocation.
There are two main problems with the typical risk questionnaire. First, most people have relatively short memories when it comes to answering subjective questions about risk. If the stock market has been going straight up for the past year or two, then people are much more likely to assume more risk than if the market has been performing badly in recent times. Second, most questionnaires are so simple that people can unconsciously manipulate their answers to reach the result they want. If, for instance, you finally get up the nerve to visit a broker because you've decided that you really want to buy into a hot international stock fund, you may well answer the risk questions more aggressively, knowing that the results will then point to the fund you want. Although a good financial advisor will go beyond the questionnaire to delve deeper to determine the most appropriate investments for you, some investment professionals lack the experience or desire to go that extra mile.
Using market declines
Because it's difficult to use theoretical exercises to figure out how tolerant you are of hypothetical market downturns, the best way to figure out your true risk tolerance is to look at how you react when the market actually does decline.
For instance, when the stock market hit its most recent lows on June 13, the Dow had fallen about 8.5% from its recent highs, and the S&P 500 had declined a bit less than 8%. However, the Nasdaq had gone down almost 13%, and an index of international markets had fallen nearly 14%. Many well-known companies, such as Home Depot (NYSE: HD ) , eBay (Nasdaq: EBAY ) , and Dell (Nasdaq: DELL ) have been hit hard over the last couple of months. This downturn has taken a number of people by surprise, and they represent in some cases the most significant declines since the bear market that ran from 2000 to early 2003.
So now is an excellent time to examine your response to the current market correction. If you are heavily invested in the stock market, have you wanted to abandon your strategy and sell all or part of your stocks? If you recall thinking that you would happily use a significant drop in stock prices to add aggressively to your stock positions, are you finding it difficult to follow through with your purchases? The best financial plan in the world won't work if the bumps you hit along the way derail your commitment to your plan.
A plan you can believe in
So what do you do if you decide you're on the wrong path? Although the best time to make a risk assessment is during a market decline, it usually isn't the best time to make major portfolio changes after prices have already fallen. Yet when the market recovers, it's easy to do nothing and dismiss your fears as being baseless.
When the markets are volatile and make it difficult to look rationally at returns on various investments, it may be best to focus on the other two factors that contribute to reaching your financial goals. Increasing the amount of savings you put toward your goals will decrease the return you have to earn to reach them. Similarly, if you are willing and able to defer your goals for a period of time, then that extra earning period will make it easier to attain your goals with less risky investments.
One method to use when you want to change your asset allocation strategy is to direct new investments entirely toward the asset whose allocation you want to increase. For example, if you currently have 80% of your portfolio in stocks and 20% in bonds and you want to move to a more conservative 60%/40% split, you would direct all new investment to bonds until they reached 40%. Unless the size of your contributions is large compared with your portfolio size, it may take several months or even years to reach the new target. Yet although this gradual approach doesn't immediately match your portfolio to your new risk profile, it does avoid selling existing investments at what may prove to be the worst possible time.
Investing is about more than just results. To be a good investor, you have to know yourself and how you will react to a wide variety of situations. By being aware of your tolerance for risk, you can create an investment portfolio that will help you achieve your goals without losing sleep.
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Home Depot and Dell are Motley Fool Inside Value selections; eBay and Dell are Motley Fool Stock Advisor recommendations.
Dan Caplinger does not own shares in any of the companies mentioned in this article and welcomes your comments.