The volatility in the stock market over the past three years has been extreme. It has forced many investors to step back and reassess their investing strategies and their capacity to handle the risk of potentially significant losses. You may be one of those investors who has felt uncomfortable with the volatility in the market and who may be wondering what to do next. It may be time to focus on the basics and reassess your current investing approach.

It’s About Risk and Potential Return

One of your major goals as an investor should be to earn a reasonable return on your investments without exposing your portfolio to too much risk. You’ll want to reach your investment goals while taking only the degree of risk you can tolerate comfortably.

Once you have determined your investment goal (how much you need to accumulate), the next step is determining risk tolerance — the ability to accept the chance of losses from an investment in return for the possibility of higher returns.

Focus on Risk Tolerance

You can measure your tolerance for investment risk by answering these questions:

How Long Before I’ll Need the Money?
If you have time on your side, all other things being equal, you can likely take on more risk with your investments. If your investments suffer losses in one year, you should have the time to recover from them. However, if you’re investing for retirement and retirement is near, it’s generally suggested that you reduce the percentage of your portfolio that’s allocated to stocks and increase the percentage allocated to bonds and cash equivalents. You’d be moving from a strategy that stresses portfolio growth to one that largely focuses on earning a more modest return and preserving whatever gains you’ve made.

What Impact Will a Big Loss Have on My Future Plans?
By viewing the impact of a potential loss in measurable, specific terms, you’ll be better able to assess your ability to absorb investment risk. What would happen if your portfolio were to decline 10% to 15% in value? Would that decline mean that your children wouldn’t be able to enroll at the colleges they’ve set their hearts on attending? Would it mean that you couldn’t afford that dream retirement home?

How Large an Investment Loss Can I Handle?
You may overestimate your ability to handle a loss. Putting a percentage loss in real dollar terms may help you better understand your own tolerance for risk. Could you sleep comfortably at night knowing that your $400,000 portfolio could potentially decline by $40,000 or more in a severe market downturn?

Diversification Is a Key Strategy

When you diversify, you are spreading your investments among different securities and asset classes. Diversification reduces the risk that your portfolio’s overall value will be seriously affected if one security or asset type performs poorly. For example, if you have all your investments in stock funds and the stock market drops, your portfolio’s value is likely to drop — perhaps significantly. But, if you diversify your investments and also hold bonds and cash equivalents, their performance may cushion the stock fund losses.

Managing and controlling the investment risk in your portfolio can help you sleep better at night and potentially bring you closer to achieving your investment goals.

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