Too often when a person starts investing, they will just throw money at whatever fund or stock sounds good at the time. They do very little research, and often just look at which one had the best performance the year before. Sometimes they will get lucky, but usually they will end up with a poorly balanced portfolio. Taking just a few minutes to figure out what their risk tolerance is, and then to learn about risk vs. reward will make them smarter than 99% of their peers.
Basically the more risk a person is willing to take in their portfolio, the better the returns will potentially be. But at the same time, more risk means a bigger loss if the stock market takes a turn for the worse. This up and down movement is called volatility.
By taking a risk tolerance questionnaire (there are many of these questionnaires online) a person can determine how much volatility they are willing to stomach. For those who are young, and have a long time horizon, their risk tolerance will be greater than those who are approaching retirement. The questionnaire will help the investor determine whether they are a conservative investor, or an aggressive one. Making this determination is the basis of a portfolio; from here the investor can then choose the proper funds.
While risk tolerance is a personal issue, there are times when a person can choose a bad portfolio for their situation. For instance, a younger person who is saving for retirement will not want to be invested in a conservative portfolio. The portfolio simply will not see the returns needed to grow enough before retirement comes. While the losses are bigger with an aggressive portfolio, the gains are too. On the other side of the coin someone approaching retirement will not want to be very aggressive with their portfolio. They have had years for it to grow, so now is time to protect the money they have. This will prevent a large market decline from wiping out up to 50% of their portfolio (as we saw happen to many people just a few years ago). But in order to figure out how aggressive or conservative to be, one must start by determining their risk tolerance.
For some, they would rather figure out their risk tolerance on their own (with the help of an online questionnaire usually). Others would rather enlist the help of a financial advisor. There are many who work for a fee, and many who work for commission. Find out who is a trusted and honest person in the community, and seek their help if you do not want to do it yourself. Otherwise make the risk tolerance your baseline, from there build a portfolio with high quality mutual funds, re-assess your risk tolerance every 2 years or so, and rebalance your portfolio as necessary. That is all there is to it, the investments will do the rest of the work.
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