How much risk can you comfortably afford to take with your investment portfolio?
The answer depends on three things:
The size of your safety zone.
Zvi Bodie, a finance professor at Boston University, says the assets that cover your needs (as opposed to your wants) should be a “safety zone” and invested more conservatively than the rest of your portfolio. Separating needs from wants is often part of a financial plan. Then, once your “need money” is invested conservatively, you can take more risk with other parts of your portfolio.
Your potential earnings.
The longer you work and the more stable your paycheck is, the more risk you may be able to tolerate with your investments. If you work on commission in a seasonal field, your salary may be as risky as a stock-heavy portfolio, so you may want to consider a more conservative investment portfolio. On the other hand, if you are a tenured government worker, your next paycheck may be as dependable as you can count on the sun rising tomorrow (unless, of course, you live in Greece). In that case, you may be able to afford a bit more risk in your investment portfolio.
Your risk tolerance.
Just because you may be able to handle risk on paper, it doesn’t mean that you can handle it in real life. If you find yourself nervously checking stock quotes hourly, a volatile investment portfolio may not resonate with your lifestyle. Risk tolerance, the willingness (not the ability) to expose yourself to loss in exchange for the possibility of gain, is highly personal and difficult to measure. And taking a risk in one area of your life doesn’t mean you’ll feel comfortable taking on risk in another area of your life. There is no reason why a bungee jumper should necessarily be invested in penny stocks.
When planning your asset allocation and investment portfolio, keep your whole financial situation in mind, and choose an asset allocation that feels comfortable. Will you be able to keep a poker face if your investment portfolio suddenly loses value?
Don’t gamble with your hard-earned money, and make sure that no matter what the market does, follow your financial plan.