One of the most important things to consider when investing is your ability to tolerate variability in your net worth. If you are in the stock market it is a venerable roller coaster and you have to be prepared for an ever shifting value of your assets. Conversely bonds are steady, but boring, and with historically low rates still around they create lower cash flow than historical averages. Real estate has historically been a great avenue that continues to increase in value, but as we saw in the last recession the value of the asset can get crushed too. All of this boils down to understanding your personal risk tolerance.
Your risk tolerance is your personal willingness to accept losses from an investment in order to capitalize on a gain. Stocks are inherently more risky that bonds, hence the larger swings in pricing in stocks and stable repayments of quality bonds. In order to understand your risk tolerance, one must understand the different categories of investors. Everyone will fall into these categories in one form or another and likely all of them over the course of their lives if they listen to general financial principles.
Conservative: You are the person who is not willing to tolerate any noticeable downside fluctuations to the value of your portfolio. You are happy to have your investments provide inflation-adjusted income to pay for your living expenses, may be on a tight budget to barely make a living as it is, and are adverse to losing what you currently have accumulated. You are the definition of risk adverse and value stability.
Moderately Conservative: You are the type of person who will tolerate a bit more risk, but generally are adverse to large short-term downside volatility in your portfolio. You want a little more return than the conservative investor, but are not willing to risk a large amount of your principle to acquire it. You are the type of person who are not willing to fully participate when markets start to rally upwards as you want to still protect a large portion of your current savings.
Moderate: This is the middle of the road and where most investors typically fall, whether you realize it or not. If you are contributing to a target date fund in your 401k, you likely have a mix of assets between stocks and bonds and are diversified and have risk mitigated. You want to have good returns, but you don’t want to lose a lot either. You fully expect to ride the market up and down, but have a core amount that is protected against significant losses. You are willing to accept a 2%-3% yield on the investment as dividends and modest capital gains.
Moderately Aggressive: You are the person who wants to outperform similar indices and when the markets are up you are not afraid to be up more in up markets, but also be down more in down ones. You are not as skiddish of investing in rising markets as other investor groups. Fixed income is minimized within your portfolio in order to achieve gains above the average investor. You expect to be up or down more than the S&P 500 in relation to your investments.
Aggressive: You feel like stepping into a cage with a wild tiger is a great idea and that by doing so you will be able to achieve superior results. A shock of 40% is not a big deal to you, even though you know it may take years to recoup your losses, if you ever do. These are typically younger investors with decades time horizons and little to no worry for their future self 30 years from now. They hold mostly growth, small-cap, and sector mutual funds and are they are typically looking for quick increases in net worth.
Understanding where you fell is imperative in being able to invest within your comfort zone and one could argue you should start in the aggressive category and move more toward the conservative side as you get older. I would counter that argument with you need to understand the market and what forces are out there that could impact your investments. Right now at historical highs may not be the time for a 20 something to be highly aggressive, but rather moderately conservative with deploying new capital.
You never want to stop contributing to your 401k, especially with a company match since it’s essentially free money, as this is a way of not trying to time the market which you should never do. However your side investment account should be used to deploy capital when it’s smart to do so. If you have a pullback it’s best to use that time to invest, not when the market tops. This is smart investing as you are picking up shares of quality companies at a cheaper price that will turn around and deliver better returns. Doing so allows you to smartly grow your wealth, while making sure that you are always deploying capital regardless of the market conditions.
So where are you readers at right now with the current markets, are you still in the aggressive camp or are you shifting toward a more conservative platform?