Your risk tolerance affects your asset allocation model, which is a major driver of your investment return. But what are the major factors that go into determining just how aggressive your investments are?
Before you invest, it's vital that you understand how well can you handle the stock market. That starts with answering these three questions.
1. How knowledgeable are you?
Are you a beginner just starting with your first investment, or are you a veteran? Your level of investor knowledge is an indicator of how well you understand how the stock market works. This can impact how you react to different market cycles.
Knowing concepts like asset allocation is crucial. Different asset classes have different levels of risk, and diversifying among them can help you limit losses. You must also understand that the stock market doesn't always go up, and the amount of volatility your accounts experience depends on how aggressive or conservative they are. Making sure your mix of stocks, bonds, and cash is in line with your objectives can help you stay invested during bear markets.
Not knowing a lot about investments doesn't mean that you shouldn't invest at all. It just means that your strategy may differ from someone who does. If your knowledge is limited, you may benefit from investing in something simple like an ETF or index fund that will require very little management and is already diversified.
2. How does market volatility make you feel?
You might take market volatility in stride and barely blink when the markets crash. Or your stomach might drop every time the S&P 500 does. Investing shouldn't stress you out. If you're constantly tapping out when the markets are down and getting back in when they're on the rise, you're doing the exact opposite of what you should do. This could lead to inferior returns.
Over a 10-year period, the S&P 500 historically has earned 7.3% on average annually and the average investor only 4.2%. That difference increases with time, with the corresponding figures for 20 years being 8.9% versus 4.7%, and for 30 years being 10.4% versus 3.7%.
Your feelings are one of the most important indicators of your willingness to take risks. If you have a workplace retirement account like a 401(k), then you can tell how you feel about risk-taking by looking at your past reactions to it. Did you have thoughts of bailing on the stock market in March of this year when coronavirus fears caused it to plummet? Or did you not pay much attention because you knew it would come back like it always does?
If you are someone who hasn't had big reactions to dips in your account balance, you can probably stand more stock exposure when you invest on your own than someone who has.
3. When will you need your money?
Do you need your money in one year or 20 years? The stock market has positive return years, negative return years, and flat years when you'll end up exactly where you started off. Predicting what will happen each year is impossible. That's why you should consider time horizons in your investing decisions.
Needing your money in a year when you're suffering losses may prevent you from reaching your investing goals. If you'd planned on retiring in 2008 and had all of your money invested in large-cap stocks, you would've lost 37% percent of your account value, causing you to potentially push your plans back. If instead, you'd planned on retiring five or 10 years later, your accounts would've recouped their losses over time.
Investments like your retirement savings that you won't need for 20 or 30 years can be invested more aggressively than money for the purchase of a new home that you'll need in a year or two. Even if you feel comfortable taking a lot of risks and haven't panicked in the past, you'll want to use conservative investments like bonds and cash equivalents if you have a short time horizon.
Putting your money in the stock market can help you reach your financial goals faster and with less money than just growing it with your contributions. But that all depends on how well you can stay invested. Make sure you're picking an investment because it matches up with your risk appetite rather than because it earns a lot. This one action can help make investing feel less like an emotional roller coaster and provide a smoother path to your goals.