You may feel comfortable taking risks when investing, but can you afford to take them? Even if volatility doesn't bother you, your circumstances may dictate how much stock exposure you should have.
That's why it's important to take into account both your risk-taking ability and your tolerance for risk before you make one single investment. You can do so by answering the following six questions.
1. What's your time horizon?
How old are you? When will you use your money? These questions are important because they help narrow down your time horizon. The sooner you will need your money, the more conservative your accounts should be. And the further you are from the expected expense (be it retirement or a major investment like buying a house), the more risk you could potentially take on with heavier stock exposure.
2. Do you have any major purchases coming up soon?
When is your next big expenditure? And how big is it? If you have $300,000 in investable assets but plan on using it within the next year for the purchase of a house, the way you invest it will be different than if your next biggest purchase is a car. If you put this money into riskier investments and the stock market experiences a correction, you could have a hard time reaching your goal. For example, if in March 2020 you had the money for purchasing a home invested in large-cap stocks, you would've seen your investments drop by 34% to $198,000 due to fears of COVID-19, and this may have delayed your plans.
3. How stable is your income?
Over the next few years will your income rise, stay the same, or fall? If your income will be reduced and your expenses don't decline proportionately, you could end up supplementing your bills by dipping into your investment accounts. And having more conservative holdings could help you avoid doing this if they end up trading at big losses. If your income will stay the same, then if nothing else has changed your risk tolerances probably won't either, and your asset allocation model will stay the same. And if your income increases and your expenses don't rise considerably as well, you may be able to withstand more risk because your higher income can better support unexpected expenses.
4. How do you react to a market correction?
If there was a significant loss in one of your investments, how would you react? How have you reacted in the past? If a stock you've been eyeing takes a significant hit, does that scare you away, or do you see it as a buying opportunity? Sometimes a great way of telling how comfortable you feel with risk involves looking at your reactions to it. If you typically have nerves of steel when the stock market is turned upside down, your appetite for volatility is probably higher than if you find yourself biting your nails and panicking about losing all your money.
5. How do you currently invest?
How diversified are your holdings? What types of companies do you like investing in? If you have all stocks, you probably feel more comfortable with risk than someone with 50% stocks and 50% bonds. And if you invest in stable companies that pay dividends, you're probably a more conservative investor than someone who buys shares in the newest tech start-up.
Find the right asset allocation model
The way you answer these questions will decide your asset allocation model or the percentage of stocks, bonds, and cash that you hold. If you are extremely averse to risk or unable to take risks because of things like a short time horizon or low liquidity, you'll probably be a more conservative investor and could end up owning mostly bonds. If you are very comfortable with volatility and your circumstances dictate that you can withstand risk, you'll probably be an aggressive investor. Your portfolio could be made up entirely of stocks.
You may also fall somewhere in the middle and be either a moderate or a moderately aggressive investor. A moderate investor lies more on the conservative side but can handle some stock exposure, maybe even up to 50% of their portfolio. A moderately aggressive investor comfortably owns mostly stock but holds some portion of bonds for downside protection.
If you invest too conservatively, the rate of return that you receive may not be enough and your accounts won't grow fast enough. But if you are invested too aggressively, you might find stock market ups and downs nerve-racking and sell out of your investments so you can avoid losses. This could lead to inferior returns. That's why finding your perfect mix of risk and reward is a vital first step in reaching your goals.