Planning Points: What is your risk tolerance?

With ongoing situations in Ukraine and the Middle East, the Fed battling our inflationary environment, new political issues happen each day.

These ongoing emotional market headlines provide plenty of reasons for increased market volatility over the past few months. And when it feels like our world is spinning out of control, it’s tempting to panic, especially when it comes to our finances.

After all, human beings are naturally averse to loss, and the pain of losing is more powerful than the potential to achieve gains.

The challenge: When we make emotional decisions and act irrationally in an attempt to avoid loss, we can lose even more. Just ask any investor who has sold stock when the market dropped and missed the recovery, only buying back in when the markets were high again.

What’s the solution? We know we need to invest to grow our money into a nest egg that will sustain us in the future, but how do you see that you don’t take on too much risk in the process?

What Is risk?

In the financial world, risk tolerance is defined as a measure of one’s financial ability to withstand permanent losses.

While you can’t completely eliminate risk in your portfolio, you can see the amount of risk you take correlates with the level of potential reward for you to gain. It is more than possible to match your investments to your goals while still being able to sleep at night during market downturns.

Here’s the thing we need to remember when we’re tempted to get out of the market ASAP: Some risks are avoidable, some are not.

Avoidable risks are those that occur when your portfolio leans too heavily on stocks or bonds that have been unstable in the past, or when your holdings are not diversified appropriately.

For example, you may be putting too much of your company’s stock in your 401(k) plan. Or you may have an overabundance of overlapping U.S. stock mutual funds instead of being more globally diversified. Avoidable risks often occur when we underestimate risk and believe we can tolerate more than we actually can.

On the other hand, unavoidable risks are those that occur because our world is ever-changing, volatile, and we can’t predict everything. As much as we wish they weren’t, unavoidable risks are simply out of our control. This type of risk includes unfortunate events like geopolitical issues and pandemics.

The third category of risk is often unseen, but it can impact your portfolio just as intensely as an obvious risk: the risk of being too conservative and not achieving your future goals as a result. By overestimating risk and trying to avoid loss at any cost, you could be unintentionally sacrificing your future dreams.

What to do about risk

Unfortunately, it’s not as simple as telling your financial adviser you feel comfortable with “moderate” risk.

Everyone has their own risk tolerance level, based on their age, life circumstances and time horizon.

It’s important to run through various scenarios with different risk levels to get an idea of how much loss you are comfortable with. If you start to panic and cringe, then you know you have hit or passed your limit.

Both positive and negative emotions frequently cause investors to make unwise decisions. If you’re excited about the upward swing of the market, you might throw caution to the wind and invest more money than you normally would. On the flip side, fear might drive you to react and sell if you start losing money.

A prudent method to identify your risk tolerance and how it may impact your financial future is using an interactive planning tool. This will allow you to create a plan that identifies your fears, goals and expectations and is able to run a variety of stress test scenarios.

This tool will provide you with a score/grade that illustrates the future impact of specific decisions you make today. Other factors such as what you’re afraid of — future health care costs, low returns, inflation, along with any possible changes in income — can be quantified and will provide information for your strategies.

By creating a wealth plan that measures your risk tolerance, you can simulate situations that cause emotional responses so you can be prepared when they happen in real time. It’s a safeguard that will help keep you focused on the long term and trust in your strategy.

Pete Alepra is managing director-financial adviser with RBC Wealth Management. Comments: (319) 368-7023; peter.alepra@rbc.com. Investment and insurance products offered through RBC are not insured by the FDIC or any federal agency, are not deposits or guaranteed by a bank and are subject to investment risks.