Getting Started in Bonds: Assessing Your Risk Tolerance

Stock certificates with financial listings
Rick Gayle/Getty Images

One of the most important steps for novice investors is accurately gauging your risk tolerance. Taking too much risk can cost you a valuable portion of your nest egg, while not taking enough risk can cause you to miss out on the opportunity for higher long-term returns. As a result, investors should strive to achieve the optimal combination of risk and return potential in their portfolios. The question is, how do you determine how much risk is appropriate?

Assessing Your Risk Tolerance: Your Time Horizon

Time is the most important element of the risk equation. While certain investments experience high short-term price fluctuations, this volatility can be smoothed out over time. In the bond market, two excellent examples are high-yield and emerging market bonds. Both are on the higher end of the risk spectrum, but both have delivered superior longer-term returns.

An investor with a long-term time horizon (five to ten years) is in a position to withstand shorter-term fluctuations in exchange for this longer-term return potential. On the other hand, someone who needs the money soon and can only hold on for a year or two needs to utilize lower-risk investments. The reason? If you happen to be invested during the time when a higher-risk investment experiences a downturn, you simply don’t have the time to make up for the loss.

For this reason, investors should avoid taking more than a very modest degree of risk with money they need for a specific purpose within the next one to two years – say, a down payment on a house, a college payment, etc.

With this in mind, the basic rule of thumb is: the shorter your time horizon, the less risk you should take. On the other hand, more time means a greater latitude to take risk, especially if you have other sources of income or a number of working years still ahead of you.

Assessing Your Risk Tolerance: How Much Volatility Can You Handle?

In some cases, even investors who can hold on for the longer-term lack the ability to take risk simply because they don’t like seeing the value of their investment go down in the short-term.

If you think you might belong in this category, higher-risk investments probably aren’t for you.

One way to assess whether an investment is appropriate for you is to look at its price history, which is easily available on free websites such as Yahoo! Finance. If you look back and see an investment has experienced sharp downturns from time to time, think about what you would do in that situation. If your first reaction would be to sell, you probably have a low tolerance for risk.

An extreme example is the performance of high yield bonds during the 2008 financial crisis. In the first eleven months of that year, most high-yield funds lost anywhere from 25% to 35% of their value. Could you have withstood such a move? If not, there’s a good chance that you would have sold your high yield bond fund when it was down and locked in the loss – meaning that you wouldn’t have been able to benefit from its subsequent recovery in the years that followed.

Generally speaking, however, investors should take the maximum amount of risk as is appropriate for their situation. While nobody likes to see the value of their investment drop – even in the short-term – taking risk generally leads to higher longer-term returns.

This is especially important to keep in mind for young people, who have time on their side.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always consult an investment advisor and tax professional before you invest.