If you want to sleep well even when markets are volatile, you must invest according to your own risk tolerance. It’s one of the most important factors in investing. Also important, however, is that risk tolerance isn’t something you set and forget. It can change over time because of personal experiences or evolving life situations.
At first, you guess how you’ll react to a bear market. Years later, you’ve lived through one or multiple market cycles. As investment experience grows, risk tolerance can change in either direction. One person can realize that market drops are too much to cope with and decide to reduce holdings in higher-risk equities. Another person may feel reassured that declines are followed by recoveries and move some fixed-income investments to equities.
Say that a 45-year-old parent has education savings heavily invested in equities for a child five years away from attending university. And a 55-year old investor is also heavily invested in equities, hoping to retire well before 65. For many years these portfolios suited each individual’s risk tolerance. But today, how well do they sleep knowing one major market downturn could jeopardize their plans? Tolerance to risk can change as time horizon shortens, usually signalling a shift toward more conservative investments.
If someone’s financial picture improves or suffers, tolerance to risk may be affected. Say that a recently divorced individual pays spousal and child support. With reduced nest egg contributions, this person may be less able to withstand portfolio losses. Lower-risk investments may be needed.
Or take someone who receives a significant windfall – an inheritance or property sale. In such a situation, investor personality determines any change in investments. One investor may allocate funds to more aggressive investments, knowing there’s a large base for long-term support. Another could make their portfolio more conservative, changing the focus to wealth preservation.
Whenever there’s a change in risk tolerance, it must be warranted. Imagine a couple approaching retirement who sacrificed large sums to help out family members. They’re thinking about investing in higher-risk equities beyond their risk tolerance to boost retirement savings. But that means going from comfort zone to danger zone – they could end up in worse shape. The couple is better off saving more, postponing retirement, earning income during retirement, or modifying their retirement lifestyle.
It’s important to talk to us whenever your risk tolerance changes so we can adjust your investments. If you become more tolerant of risk, you’ll have new investment opportunities. If you become less tolerant of risk, we’ll ensure that you meet your investment goals while enjoying peace of mind.