When reviewing your portfolio, it’s important to understand not only historical returns but how much risk was required to get those returns. For instance a 6 percent unsecured loan to a friend probably has much more risk than an investment grade bond yielding 6 percent. Portfolios with low risk are more desirable to portfolios with higher risk. Risk-adjusted returns take into account how much risk was required to achieve those returns.
Just because your portfolio has been performing well doesn’t mean it is a good portfolio or appropriate for your risk tolerance. It is very important to know exactly what your risk tolerance is.
Everyone would be glad to accept a 10 percent annual return but most people differ on the level of risk that they would be willing to accept in order to get that return. Some people can tolerate a 40 percent loss, similar to what occurred to many stock portfolios in 2008, while others can only stomach much less potential loss. It is critical that you periodically have your portfolio evaluated to determine the potential downside risk before the next market correction. If you are judging your portfolio only based on recent returns, you may be in for a rude awakening the next time there is a significant market correction. It’s perfectly fine to be an aggressive investor, as long as you understand and are comfortable with the risk that you are taking. Investors should make sure that their portfolios are designed in a way to limit the downside risk to a level that they are comfortable with. Otherwise they could wind up losing much more than they are comfortable with.
For those who wish to quantify their risk tolerance, they can go to singerwealth.com and click the button at the top of the page to determine their risk tolerance.
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