Big swings in the stock market can be confusing for investors. Should you buy or sell? Or do nothing?
There's no right answer. It really depends on what kind of investor you are. When you know yourself as an investor, tumultuous times in the market can be easier to deal with.
To determine what type of investor you are, think about your personal limitations, as well as your strengths and weaknesses. Are you patient? Do you tend to get nervous when times are tough? How well do you handle risk? Do you like to take chances?
Depending on your answers, an investment adviser would decide that you are either a conservative, moderate, or aggressive investor. But those labels are too broad and don't specify how much risk you're willing to take.
Risk tolerance is hard to determine and different for each person. No one likes to lose money. But most people understand they have to accept some risk in exchange for having their investments go up over time. However, they may not understand it until they experience what it feels like when their investments lose value.
Figure out how you would react to market movements by answering this question: If you look at your investments this month and see they're worth 10 percent less than they were the month before, what would you do?
1. Sell everything right away.
2. Be concerned, but take no action and continue to monitor them.
3. Invest more money because it's a great buying opportunity.
If you pick the first response, you generally don't like to see big changes in the value of your investments. If you pick the second, you're calmer and would likely change your holdings only as necessary based on your investment plan, not market volatility. And if you picked number three, you're comfortable with swings in the market and are willing to take chances.
This question and others like it attempt to put you in the moment to identify your emotions and motivations. Through your responses, you'll have a better idea of how much risk you can handle.
Now that you have determined your risk tolerance, you can start creating an investment plan. Before doing that, you must understand what you're trying to accomplish. Think about where you are in your life when you're setting your goals. Everyone has to save for retirement. You might also want to buy a home, start a business, or put money aside for your child's college education.
Then you have to ask yourself how you can reach those goals. Is it important that you don't lose any money with your investments? How much do you need to make from your investments to achieve your goals? Your answers will help shape your investment plan.
If you want to minimize risk in your investments, your account will include more conservative items like money market funds or treasuries. If you want or need your investments to have the potential for larger increases, your account will include more aggressive items like growth and value stocks. If you're somewhere in between, you'd likely own a mix of conservative and growth-oriented investments.
You also have to identify what type of return you want to generate from your investments. Are you trying to keep pace with inflation? Or do you want something closer to the returns provided by the stock market? These answers will also help determine what types of investments are best for you.
Once you decide how comfortable you feel about taking risks and seeing swings in the market, identify your goals, and decide how you want to reach those goals, you can create an investment plan that suits your personality and needs. Then, when the stock market gets chaotic, you'll rest easier knowing that your plan reflects who you are as an investor.
Adam Bold is the founder of The Mutual Fund Store, which provides fee-only investment advice with locations coast to coast. He's also host of The Mutual Fund Show, a call-in radio program broadcast across the country. Bold is author of the book The Bold Truth about Investing (April 2009). Bold is Chief Investment Officer of The Mutual Fund Research Center, an SEC-registered investment adviser, which provides mutual fund and asset allocation recommendations, and research to stores in The Mutual Fund Store system.