And that’s why you need to be sure of your risk tolerance. If you have a high tolerance for risk, you may be willing to accept significant price fluctuations in exchange for potentially higher returns—keeping in mind that risk and reward are directly related. But if your risk tolerance is low, you probably want greater stability in your investments—and to achieve this stability, you can live with lower returns.
Unfortunately, many people misjudge their own risk tolerance. This can lead to problems, such as these:
• Too much stress—Over the long term, financial markets have trended upward. But over the short term, the markets will fluctuate, with downturns that last weeks, months and even years. If you believed you could tolerate a high degree of risk, but you found yourself losing sleep over these market slumps, then you may need to re-evaluate your risk tolerance and possibly rebalance your portfolio so that it’s somewhat less susceptible to market volatility.
• Too little growth—Just as you can over-estimate your risk tolerance, it’s also possible to underestimate it. If you think you simply can’t take much investment risk, you’re likely to load your portfolio with certificates of deposit (CDs), money market accounts and other fixed-income vehicles that offer strong protection of principal but little opportunity for growth. However, if you’re going to achieve your long-term financial goals, such as a comfortable retirement, you will unquestionably need some growth potential in your portfolio. To combat your perceived low tolerance for risk, you may want to diversify your holdings to include growth vehicles such as stocks along with more conservative investments, such as bonds and CDs.
Thus far, we’ve discussed risk tolerance in relation to the risk of losing principal when the value of your investments drops. But you also need to consider another type of risk: the risk of losing purchasing power.
Purchasing-power risk largely applies to fixed-rate investments such as CDs and money market accounts. To illustrate: If you purchase a CD that pays 2 percent, and the inflation rate is 3 percent, you are actually losing purchasing power. Over time, these losses can seriously erode the value of your savings.
So if you are concerned about fighting inflation, you may want to look for investments that have the potential to offer rising income, such as dividend-paying stocks. (Be aware, though, that companies can reduce or eliminate dividends at any time.)
You can’t totally avoid all the risks associated with investing. But by being aware of your risk tolerance, diversifying your portfolio and taking steps to stay ahead of inflation, you can improve your chances of making steady progress toward your financial objectives.
This article is provided by John Barnes , a Financial Advisor at RBC Wealth Management. The information included in this article is not intended to be used as the primary basis for making investment decisions. RBC Wealth Management does not endorse this organization or publication. Consult your investment professional for additional information and guidance.
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