The more risk you take when investing, the more potential there is for your accounts to grow. But on the flip side, the riskier your investments, the more they could suffer if the market turns against you.
Finding the optimal level of risk you should take on is unique to you and could change over time, but it should always take into consideration these five questions.
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1. What is your investing time horizon?
When will you need to tap into the savings in your accounts? If you experience stock market losses, the longer you have before you will use your money, the more time you will have to recover those losses. For example, if you invested $100,000 into large-cap stocks at the beginning of 2001 with the intention of using it at the beginning of 2003, your portfolio value would've declined to about $68,637 because of the dot com crash. If instead, you needed those funds at the beginning of 2007, your accounts would've recovered and grown to $118,963. If you didn't need that money until 15 years later at the beginning of 2016, your account balance would've more than doubled and been worth $207,938.
That's why your appetite for risk should be greater for accounts that you will use in 30 years versus five years. And since you don't know when a bear market will happen, how severe it will be, or how long it will last, some accounts -- like ones that you plan on using over the next year -- should be kept out of equities entirely.
2. How do you feel about volatility?
You can get a good understanding of how you feel about volatility by examining your past reactions to it. Have you taken it in stride, or did you find yourself panicked? Are you dreading another potential pullback? Have you actually sold your investments and realized losses?
For investors who haven't reacted well to stock market volatility in the past, investing in just stocks may not be suitable for you. You may find that your nerves are calmed by reducing your market exposure -- adding investments like bonds or commodities can help you accomplish this.
3. How stable is your income?
Do you have income that is very secure, or is there a good chance that you could lose your employment soon? Does your income fluctuate from month to month because of variable payments like commissions? Or is it fixed and stable?
A loss in wages might result in you dipping into your savings. If there is a market downturn in addition to economic instability, you don't want your savings exposed to the double-threat of reduced income and investment losses. The more reliable your income is, the less likely this scenario is and the more risk you can take on. But if you work in an industry where layoffs are frequent, or one most affected by current economic factors, you should take less risk in the event that you need your invested money in the near future.
4. Do you have an emergency fund?
If you can't pay your bills and sustain your livelihood, you may find yourself more afraid of a stock market correction. An emergency fund can help alleviate these concerns. Most experts agree that you should have at least three months of your expenses set aside in cash, and six months is optimal.
But during periods like now when people are losing their jobs in greater numbers due to COVID-19, saving so you can cover even more time may benefit you. If you have a worst-case scenario like losing your job, your emergency fund can supplement or replace your income and cover essentials like your mortgage or car loan instead of dipping into your investments.
5. What are you saving money for?
Is this fun money that you're investing so that you can satisfy your love for trading, or is it money earmarked for your retirement? If it's money comprising a small portion of your overall assets that you don't have any specific plans for, you may be able to invest it more aggressively than funds you have a very specific purpose for -- like sending your children to college.
Losing money in a fun account may only mean that you forgo a luxury vacation or new car. But for more important uses, you should carefully consider the level of risk you're adopting and how that risk could turn against you.
With that in mind, if you end up overly risk averse, your investments may not provide sufficient returns. This can make finding the right balance tricky. Answering these key questions should make discovering your optimal approach easier as you seek to meet your financial goals.
