Is It Time to Reassess Your Risk Tolerance?

Market shocks are an inevitable part of investing—but that doesn't make them any easier to stomach. Whether you're just starting out or you've been saving for decades, watching the value of your hard-earned gains drop overnight can cause you to question the entire enterprise.

When the market is going up, it's easy for investors to think they're more comfortable with risk than they actually are. But whenever the S&P 500^® Index drops into bear-market territory, people may be forced to confront their true risk tolerance—as well as their capacity, or ability, to take risk. 

So, how do you go about reassessing your tolerance for risk, come what may? Ask yourself these three questions.

Investing is an act of faith—to say nothing of willpower. The assets that offer the highest potential reward are often the riskiest, but if you can steel yourself against occasional surges in volatility, you're more likely to reach your long-term goals.

The question is, how much risk can you really handle? To help answer that question, consider the downsides and upsides of five hypothetical portfolios:

Although portfolios with larger allocations to stocks have historically delivered higher returns over time, they have also been more volatile—which may not work for everyone. If you need the money in the next few years, for example, you should choose a more stable investment mix. The same is true if you simply can't bear to see your portfolio plummet in value.

It's perfectly reasonable to accept lower returns in exchange for more stability, but depending on your objective, that may mean you may have to save more—or ratchet back your expectations—to compensate.

Indeed, reducing your exposure to stocks and other relatively higher-risk, potentially higher-reward assets during your peak earning years comes could cause you to fall short of your goal. Market turbulence feels risky because it's something you have to face again and again. But if you have long-term goals, the more pernicious risk comes from undercutting your long-term returns because there's often no coming back from that.

While many people think about risk in terms of their ability to endure losses emotionally, there's another component to risk that's equally important: your capacity to recover financially. 

Time is a big factor here. When you've got a decade or more until you need to tap your savings, short-term volatility isn't a big risk. But if you'll need the money in, say, five or fewer years, a market downturn can be devastating.

Be that as it may, your financial capacity for risk may not square with your emotional tolerance for it. An investor in their 40s, for example, probably has 20 or more years until retirement, which should allow them to invest aggressively. But some people simply can't tolerate the ups and downs of holding that much stock, regardless of their age or time frame.

Conversely, even aggressive investors can be waylaid by adverse life events like losing a job. If you need to tap your long-term savings to make ends meet, your capacity for risk can shrink overnight. In such situations, downshifting your exposure to help preserve capital could absolutely be the right approach.

Of course, in a perfect world your financial plan would have a built-in cushion for such emergencies. With an emergency fund in place, you're less likely to need to tap your long-term investments to cover short-term expenses. 

Nonretirees should maintain at least three (and ideally six) months' worth of essential expenses in a highly liquid account. However, if you're nearing or in retirement, it may make sense to increase your emergency fund savings to support at least a year's worth of spending, and then in a separate account or as part of your portfolio, dedicate another two to four years' worth of anticipated expenses to historically more stable investments such as high-quality bonds or bond funds. Keeping that much cash and short-term investments can help you avoid having to sell assets during a downturn.

It's difficult for investors to predict in advance how they'll respond to a given set of market conditions, such as a down market, until it occurs. Consider asking someone close to you to rate your risk tolerance. You might think you're comfortable with risk, but your spouse or a close friend may be able to identify patterns of behavior—such as your tendency to play it safe in other areas of your life—that you're unable to recognize in yourself.

Financial advisors are ideally suited to this role because their experience with a broad range of clients can lend some perspective on where you fall along the spectrum of risk tolerance. As they get to know you, they can remind you how you felt, or reacted, in prior down markets and may also be able to help you identify whether you're acting with your head—or your heart. 

An advisor can help you "ignore the noise," like short-term market fluctuations and sensational headlines, to curtail the emotional responses that might otherwise get the best of you. In fact, one of the most significant services an advisor can provide is helping you stay the course—based on a true and impartial assessment of your risk tolerance as well as your capacity to take risk—should you ever need money from your portfolio during a market downturn.

You can't wish your emotions away, but try to keep them in check. An advisor can guide you through reviewing your portfolio against your broader financial plan during market swings—as well as anytime your situation changes substantially.

While it's wise to take into account your age and time frame when managing your portfolio, your risk tolerance ultimately comes down to figuring out how much risk you can really afford financially, and handle emotionally. Once you know that, you can put together a plan that balances your long-term need for growth with your near-term need to manage your impulses.