Risk and Perspective: 2 Investing Essentials

Fall back on your financial plan and your investment strategy, not feelings of fear or greed.

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The financial markets have been on a wild roller coaster ride over the past several trading sessions, and most of the ride has been tilted to the downside.

In periods of extreme volatility, there are two essential elements to investing: The ability to assess risk and the ability to view things with perspective.

Risk assessment entails both assessing the risk of your investment portfolio, and assessing your tolerance for investment risk. In the world of investment advisers there are many measurements of risk, but let's focus on the only one that seems to really matter to investors: the risk of losing money in your investments.

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A simple test during times of extreme, quick market drops is picking a time period—say a week or a month—and calculating the change in value in the portfolio. Then take several broad market indexes such as the S&P 500, the Russell 2000 (small-cap stocks), the S&P 400 Midcap index, the MSCI EAFE index (foreign stocks), and perhaps the Barclay's U.S. Aggregate Bond Index. Calculate the change in these benchmarks over the same time period. (Easy proxies for these indexes are exchange-traded funds (ETFs) or index funds that track these benchmarks.)

How did your portfolio compare to these indexes? While hardly a perfect barometer, this will give you a sense of how your results compare to the headlines we are all hearing about a market meltdown.

I track portfolios on a more formal basis using weighted benchmarks of various indexes that are tied to the target allocation for each client.

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Also, consider how your portfolio has held up compared to the "market." Have you lost more or less than you expected? While I don't like to make investment decisions based upon short periods of time, market declines like the one we are currently experiencing provide an excellent "stress test" for your investments.

The second piece of risk assessment is how does the performance of your holdings make you feel, especially combined with the constant bombardment of bad news in the media? Are you inclined to stay the course and perhaps rebalance your holdings in line with your investment strategy? Or are you inclined to sell and hang on for dear life?

Perspective is vital. The market has declined severely and swiftly. Still, the S&P 500 is up some 70 percent from the March 2009 lows of the last protracted market decline.

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Moreover, how does this recent market decline impact your longer–term financial planning? Are you still on track toward your goals? Are you inclined to sell everything and go to the safety of cash? What did you do during the longer-term market declines of 2000-2002 and 2008-2009? Are you happy with the results of these actions?

With the ever-increasing coverage of the financial markets, we are bombarded with information and news. It is always wise for investors to step back and assess their own situation in light of what is happening in the markets, whether the news is good or bad. Fall back on your financial plan and your investment strategy. Don't react to feelings of fear or greed.

Roger Wohlner, CFP®, is a fee-only financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill. where he provides advice to individual clients, retirement plan sponsors, foundations, and endowments. He recently cofounded Retirement Fiduciary Advisors to provide direct investment and retirement planning advice to 401(k) plan participants. Follow Roger on Twitter and LinkedIn. Roger also blogs at Chicago Financial Planner.