Your risk tolerance dramatically impacts the investments you pick — and the overall performance of your portfolio. Yet many people don’t take the time to actually think through what risk tolerance means to them and their ability to handle losses.
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A recent fund manager survey found investors’ risk appetite is increasing. Does that mean yours is, too?
Taking the time to figure out your risk tolerance can help you align your investment picks with your financial goals. Here are three questions to ask yourself before you invest.
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1. How Do You Handle Change?
Are you easygoing? Or are you less adaptable to change? This can signal how well (or not) you’d handle market volatility.
How do stock prices make you feel when they swing, especially during sharp sell-offs? If watching daily market ups and downs makes you anxious, you likely fall lower on the risk tolerance scale (and may want to stick with more conservative investments). If volatility disrupts your quality of life, lowering your exposure to volatile assets is smart.
On the other hand, some investors feel energized analyzing daily market movements and see volatility as an opportunity. Risk-tolerant investors may have the personality type that loves the adrenaline of roller coasters and doesn’t mind a few bumps in the road to reach their long-term goals.
2. What Are Your Financial Goals?
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Consider why you’re investing. Are you saving for a long-term goal like retirement? Or do you need this money in the next couple of years? Your goals and time horizon should guide how much risk you should take on.
The longer your time horizon, the more your money has to grow and weather any short-term volatility.
Younger investors have more time to recover from downturns, research by the University of Utah found. This means they could consider more aggressive investments with higher risk and higher potential returns.
If you’re nearing or in retirement — it may be wiser to lock in steady gains through dividends so you don’t run out of money. Your situation matters when determining the proper risk level.
3. How Much Do I Know?
There’s lots to learn about investing — and you can choose to go as broad or deep as you want, from basic index funds to complex derivatives trading.
But ideally, you only want to invest in areas with enough knowledge to understand what you own and why. If you can’t fully make sense of an investment and its risks, it’s best to steer clear.
Most beginner investors should consider starting with diversified index funds that match their goals.
When investing, it’s natural only to want to focus on what earns the highest returns. You should also think about the risk that comes with higher returns.
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Investors with higher risk tolerance can endure more volatility to seek higher returns. Those with lower risk tolerance may accept more modest returns for greater stability.
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This article originally appeared on GOBankingRates.com: 3 Questions To Ask Yourself Before Investing
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