Is Market Volatility Testing Your Risk Tolerance?

A man looks out a window.

Recent market volatility may have you rethinking the amount of investment risk that's right for you. Here are four key ideas to consider.

The recent ups and downs of the markets during the coronavirus pandemic could have you rethinking how comfortable you actually are with investment risk. After all, it can be hard to stomach some of the extreme drops in value that have occurred, even if prices have recovered–although not returning to their record highs. If you’ve found yourself questioning your risk tolerance lately, what should you do to reassess so that you’re better positioned now and going forward?

First, don’t get caught up in the minute-by-minute fluctuations in the market, says Tracie McMillion, Head of Global Asset Allocation Strategy for the Wells Fargo Investment Institute. Instead, base your overall risk tolerance on your goals and your overall timeline. Volatility is a normal part of the markets; knowing your ultimate objective and the amount of time you have to get there can help you focus on the amount of risk you might be willing to take.

Here, McMillion describes what investors should consider when it comes to the factors that can help determine an acceptable level of risk tolerance.

1. Identify your goals—and reevaluate regularly

Your financial goals are intertwined with your personal life and with the markets. And all three can change.

Your personal goals and the state of the markets are what guide your asset allocation McMillion says.

Over time, your goals can change. Investors just starting out may be saving for goals like a down payment for a home, college education for their children, and retirement. As they progress through life, they may achieve these goals and set new ones such as buying a rental property or creating a legacy by supporting a charitable organization.

McMillion recommends that you revisit your goals at least annually; that way, you can keep them in line with your evolving financial situation and life priorities. Your investment professional can help you make sure your portfolio aligns with your objectives. 

2. Set your time horizon

Each of your life goals will have a time horizon for reaching it. Once you have set an objective and a corresponding time horizon, you can consider the amount of risk likely necessary for reaching your goal on time. If the amount of risk involved is outside of your comfort zone, you may decide you want to extend your time horizon.

Adjusting the time horizon on your goals is part of your financial planning. If you’re planning to make a major purchase, for example, it might start as a long-term objective but move into intermediate and then short-term as time passes. Consider three time horizon categories:

  • Long-term horizons can mean having the freedom to choose riskier investments with a higher potential rate of return.
  • Intermediate horizon may have a mix of assets that typically exhibit lower volatility and those that can grow and may see some volatility.
  • Short-term time horizons match well to stable assets and usually mean focusing on shorter term bonds and cash or cash alternatives, which generally means less investment return.

Furthermore, your time horizon may suddenly shift. If, for example, your plan were to retire in 10 years and the business you own is impacted by circumstances beyond your control, your long-term goal could become a short-term objective—and in that case, your financial plan will need to adjust. 

3. Determine your risk budget

This year has shown just how unpredictable markets can be. As an investor, you need to assess how much risk you are willing to take. You can call this your risk budget.

Your financial budget comes from balancing your income and your expenses; your risk budget comes from balancing the amount of return you’d like to achieve and the total amount of risk that you’re comfortable taking. A risk budget can be met by balancing higher risk—and potentially higher-return—investments such as stocks, with lower-risk, and often lower-return, investments.

You can start with a projected amount desired for future needs, and working with your investment professional, you can then determine what rate of return is needed to achieve it. From there, you can determine what your investment allocations might be, based on how much risk you’re willing to take. People’s risk budgets generally shrink over time as they progress towards their goals, McMillion says.

If you have a low risk tolerance, you might have a portfolio mix with a significant amount of bonds or other lower-risk investments. If your risk tolerance is high, your portfolio might lean more toward stocks and higher risk alternative investments. Your advisor will use those risk budgets to determine the expected return for the risk you’re comfortable taking.

4. Your financial success depends on planning

Having an up-to-date financial plan aligned to your goals, time horizon and risk tolerance is the key to helping you stay on track when the market is fluctuating. McMillion recommends reviewing your financial plan and your corresponding portfolio allocations regularly with an investment professional.

When you do so, she says to know the answers to these questions:

  • What are your financial and life goals?
  • What are your time horizons for these goals?
  • Do you have a plan to liquidate certain assets to fund the goals or will you rely on income generated from your investments?
  • What are your current and future expected tax circumstances?

“If you found the recent market volatility unsettling and think it may be time to make a change,” she says, then it’s time to talk it through with your investment professional.”

Wells Fargo Investment Institute, Inc. (WFII) is a registered investment adviser and wholly-owned subsidiary of Wells Fargo Bank, N.A.

All investing involves risk including the possible loss of principal. Foreign investing presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.

Diversification does not guarantee profit or protect against loss in declining markets. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns.

Alternative investments, such as hedge funds, private capital/private debt funds, and private real estate funds, are not appropriate for all investors and are only open to “accredited” or “qualified” investors within the meaning of the U.S. securities laws. They are speculative, highly illiquid, and are designed for long-term investment and not as trading vehicles. There is no assurance that any investment strategy pursued by the Master Fund (and thus the Feeder Fund) will be successful or that the fund will achieve its intended objective. Investments in these funds entail significant risks, volatility and capital loss including the loss of the entire amount invested. They are intended for qualified, financially sophisticated investors who can bear the risks associated with these investments. Investors should read the fund’s offering documents prior to investing.