There are millions of different investments you can buy, and they all require you to consider the same key tradeoff: risk versus return.
Generally speaking, the greater your investment’s potential returns, the more likely it could decline precipitously in value. When you’re looking to maximize your portfolio’s return, ask yourself: What would a big decline in my investments do to me?
The question requires a multifaceted answer — one that examines both how a dip in your portfolio would materially affect your finances and how you react emotionally to losing money.
Many investors have been able to answer that question firsthand of late. The broad stock market fell nearly 24% between January and mid-June, and many individual stocks and more volatile assets, such as cryptocurrencies, fared far worse.
If recent market volatility hurt a little more than you thought it might, consider taking a moment for some introspection, says Christine Benz, director of personal finance and retirement planning at Morningstar.
“A lot of people entered the market in 2020 and 2021 simply because it was going up,” Benz tells CNBC Make It. “Now’s a good time to take a deep breath, step back and think about what’s the appropriate amount of risk to be taking in your portfolio.”
Here’s how to make sure you’re investing with the right level of risk, according to market experts.
Understanding risk capacity and risk tolerance
Back to the central question: What would a big decline in the value of your portfolio do to you?
First, a dip in your portfolio would materially affect the rest of your financial picture. That’s called your risk capacity. If you’re years away from a long-term goal, such as retirement, short-term dips in your portfolio aren’t necessarily a very big deal because your investments have decades to recover.
If your goal is in the near future, however, a big loss could derail your plans. If you had some of your portfolio earmarked for a down payment on a house this year, for instance, you may not be able to afford a…
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