The recent turbulence in financial markets is another reminder that there’s a short-term price for earning attractive returns over the long run. It was easy to overlook this reality when stocks were racking up impressive gains for much of the past decade. But when the party ended recently, as it always does eventually, many investors discovered that their tolerance for market risk was lower than they assumed when the bull market was roaring.

The problem isn’t with markets. Stocks will recover, as they have after previous crashes. Yes, this time is different and the recovery may take longer. But while the timing of the market’s rebound is unclear, better days are coming. Meantime, the latest upheaval in equities offers one more teachable moment for understanding risk tolerance on a deeper level.

Before you invest, it’s essential to recognize your limits for psychologically enduring the market’s periodic tendency to suffer sharp corrections. Most investors say they can sit tight – when the market is rising. Not surprisingly, many of those estimates go through a dramatic attitude adjustment when the market cracks.

A qualified investment adviser can help you identify what you’re really able to withstand (or not) in terms of market volatility – before a market correction forces you to confront reality.

As you might expect, everyone’s different. What you think is a reasonable level of risk can look frightening to another investor.

Measuring risk tolerance can get complicated, but at a basic level the objective is twofold: 1) estimate the amount of risk you need to assume to achieve your financial objectives and 2) forecast your ability to stick to your investment plan if markets crash.

Several factors come into play when evaluating risk tolerance. Some of the most significant are age, time horizon, personality type, along with other variables that reflect who you are as an investor.

Once you have a solid understanding of your capacity for bearing risk the focus turns to building a customized portfolio that’s consistent with it. As a simple example, consider a basic stock/bond portfolio, based on two mutual funds: Vanguard 500 Index Fund (VFINX) for stocks and Vanguard Short-Term Federal Fund (VSGBX) for bonds. By adjusting the weights for these two funds – a.k.a. changing the asset allocation – we can customize an investment strategy.

For instance, the chart below shows how different mixes of stocks and bonds (with year-end rebalancing) fared over the past 30 years. Higher weights in equities earned higher returns through time, but at the cost of severe short-term corrections. Portfolios with higher bond allocations delivered a smoother ride and suffered less in bear markets, but at the price of lower returns.

For investors who can stay the course when encountering bear markets, the payoff for bearing more risk can be substantial. But there is a natural temptation to over-estimate our tolerance for risk when the markets are calm, only to be overcome by the urge to sell when a bear market sets in. That’s a problem because selling stocks during a bear market, and then buying them back during a bull market is a losing investment strategy.

The solution is finding the portfolio that’s suited to your risk tolerance. The first step is understanding your risk tolerance. If you get that wrong, your odds for investment success are low. Fortunately, there’s a solution – talking with an investment adviser to understand how much financial pain you can withstand, or not, during market storms.

At The Milwaukee Company, we believe that rules-based investment strategies that are supported by academic research and thoroughly tested is an effective way to manage investment risk. We have developed several strategies that target various levels of risk by tapping into various asset classes on a global basis. We also apply additional risk-management techniques to further refine portfolios to satisfy a client’s investment objective and risk profile.

Next time, we will discuss tactical asset allocation, a core component of these strategies.

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Andrew Willms is president and chief executive officer of The Milwaukee Company (themilwaukeecompany.com), a wealth management firm based in Thiensville, Wisconsin. You can subscribe to his investment blog at www.themarketcommentator.com, or follow him on Twitter at twitter.com/mrktcommentator

Is It Time To Rethink Your Tolerance For Investment Risk?