Unless you’re an adrenaline junkie who loves taking risks, the thought of putting your hard-earned cash on the investing roller coaster probably makes you nervous. Some people are able to gut out those ups and downs better than others. Your level of comfort with these swings is called your risk tolerance.
Financial advisors can help you measure your risk tolerance though any number of quizzes, questionnaires, calculators or charts. But that won’t be much use if you don’t know what it means or how it can affect your capacity to build wealth through investing.
Think of your risk tolerance as a two-sided coin—one side financial, the other side emotional. Each is equally important in determining how much risk you can handle when you invest for retirement.
Debt amplifies risk. It’s the reason people panic at the thought of a job loss. They have to keep up their income so they can make their payments.
Investing while you’re in debt is also riskier because you’re actually investing money you could use to pay down your debt. If your investments lose value, you’ve lost that option. That’s why you should only invest when you’re out of debt and have a fully funded emergency fund.
Your emergency fund reduces your risk even further. You won’t be tempted to empty out your retirement accounts to pay unexpected expenses when you have a nice cushion saved up to cover them.
Living debt-free with the security of an emergency fund should give you the emotional boost you need to jump head first into investing and stick with your long-term plan even when the markets take a dive.
But emotions aren’t rational. The first time your investments take a hit (and they will), fear often takes over. All you want to do is pull your money out of your investments and stuff it in your mattress. In your head, you know your financial security isn’t in jeopardy, but your heart simply can’t handle the dwindling number in your investment balance.
The pendulum swings the other way as well. When your investments are up, you could convince yourself that you’re too smart for simple investing, so you look for more sophisticated investment strategies to try to take advantage of short-term stock market gains.
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In both cases, you can make serious mistakes that can ruin your chances of building a healthy retirement fund.
Risk Management, Ramsey Style
By only investing when you’re debt-free with a fully funded emergency fund, you take the first steps toward reducing your investing risk. You can take things a step further by investing in mutual funds with a history of above-average returns. Mutual funds spread out your investments between many—sometimes hundreds—of companies, so you aren’t dependent on the performance of just a few businesses.
Choosing different types of mutual funds also helps minimize your risk while still taking advantage of the wealth-building power of the stock market. Choose an equal number of mutual funds in these categories: growth, growth and income, aggressive growth and international.
Get Personal Advice for the Tough Times
Knowing your risk tolerance helps you become a better investor since you’re more likely to choose investments you can stick with long term. As we mentioned, a financial advisor can help you determine how much risk you’re comfortable taking on.
Your advisor can also show you how to choose investments that line up with your risk tolerance so you don’t end up with investments that swing wildly and leave you feeling panicky—and maybe a little nauseous.
By taking these steps (and the ones mentioned above), you set yourself up for a successful investing experience—both financial and emotionally.
You can find a financial advisor you can trust through Dave’s nationwide network of investing Endorsed Local Providers (ELPs). Your ELP will help you keep your plan on track when the stock market soars and when it tanks. Find your ELP today!