You may never know your risk capacity in the stock market until something bad happens. If you sell your stock holdings at the first sign of trouble, you could be in for some big losses.
To avoid selling at the wrong time, it can be a smart move before investing in stocks to know what your risk capacity is. What’s your comfort zone?
Here are some ways to measure your risk capacity before you start investing in the stock market:
How far is your horizon?
Stocks are usually considered long-term investments, though one person’s definition of long-term can vary from another.
The longer your time horizon, the more risk you can take on with risky assets like stocks and bonds. For short-term financial goals, cash investments may be appropriate and have a much lower risk capacity than stocks.
You could lose it all
With securities, you could lose some or all of your principal — meaning the amount you’ve invested — if the stock falls enough and doesn’t recover. Securities aren’t federally insured, potentially leaving you with nothing if the market crashes and you decide to get out.
Consider a mix
The potential reward for taking on higher risk in the stock market, for example, is a greater investment return. Note the word “potential.” Nothing is certain here.
To lessen some of that risk, an investor can invest in different asset categories — stocks, bonds and cash. Historically, the returns on those three don’t move up and down at the same time.
Market conditions can cause one to perform well and another to do poorly. Investing in all three categories can reduce the risk that you’ll lose money overall.
Asset allocation can help you achieve your financial goals, and taking on more risk by buying stocks can lead to bigger long-term returns.
Test your risk capacity
Some financial advisors offer questionnaires to help measure how much risk capacity you have to meet your objectives.
If they find you have a high risk requirement and a low risk tolerance — such as needing money soon for retirement but an unwillingness to buy stocks — then they may set a more realistic return expectation.
The questionnaires about your risk capacity will gauge your acceptance of a certain level of volatility. For example: “If you lost 10 percent in a market correction, buy more, sell everything or stay the same?”
Risk aversion can be just as dangerous as risk acceptance, such as if you’ve been through a recent recession and don’t want to deal with such losses again.
Are you a ‘value’ investor? Watch out
While the stock market in general is a risky investment, certain stocks are riskier than others. You should know ahead of time what your risk capacity is for these stocks.
Two types of stocks: “growth” and “value,” can be very volatile and have different risks over the long-term.
“Growth” investing is in companies with rapid growth in revenue and profits. “Value” investing is in companies with slow growth, difficult business conditions and possibly declining revenues and profits.
Value stocks historically perform higher than growth stocks, and have higher risks for investors. Value companies may outperform over the long term, but are likely to underperform the market for shorter periods.
Knowing your risk capacity for such long-term stocks is important before buying them.
A financial advisor can help you determine your risk capacity for securities, and can back up their recommendations with statistics and historical data.
But ultimately, it’s up to you to determine how much risk you’re comfortable with and how it fits in with your short- and long-term financial goals. Without such a roadmap, you’re lost before you even begin.