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Assessing a client's risk tolerance--an individual's own assessment of his or her ability to withstand investment losses--is standard practice in the financial-planning world. The Web is full of tools to help investors gauge how they would respond if the market dropped 10%, 20%, or even 50%, and I often hear from readers who tell me that their risk tolerance is "high" or "low."
The basic premise behind getting investors to identify their pain thresholds makes sense. After all, reams of data, including Morningstar's Investor Returns, show that investors often buy high and sell low. By identifying their ability to handle losses and avoiding those investments that will cause them to sell at the wrong time, investors should be able to improve their overall return records.
Yet relying disproportionately on your risk tolerance to shape your investments carries its own big risk: namely, that you'll end up with a portfolio that doesn't help you reach your goals because you've been too aggressive or too timid. Instead, risk tolerance should take a back seat to the really important considerations, such as the size of your current nest egg, your savings rate, the years you have until retirement, and the number of years you expect to be retired. Only after you've developed a portfolio plan based on those factors should you consider making adjustments around the margins to suit your risk tolerance.
The Risk of Being Too Aggressive
Generally speaking, I'm happy to hear from investors who rate their risk tolerance as "high." These folks' |
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