Typically, before deciding how much to allocate to different investment categories, you answer several questions about your tolerance for risk. Stock market fluctuations can provide a real world test of your theoretical answers and help you gain a better understanding of your comfort level with risk.

There are at least two components to your risk tolerance. One is the appropriate level of investment risk based on your personal situation. Factors such as your time horizon for investing, income level, total assets, debt levels, liquidity, and family responsibilities will affect that decision.

 

The other element is your emotional tolerance for risk. Even if your personal situation indicates a high level of risk, that may not be prudent if you don't feel emotionally comfortable with that risk.

Divvying Up Your Dreams     Your willingness to take risk with your investments is not necessarily a static concept. You may be less willing to take risk with investments designated for a financial goal you consider essential, while more willing to take risk for nonessential goals. However, those varying risk levels may be difficult to assess if all your investments are commingled in one account.     For instance, assume you have three goals: to ensure you have enough funds to support yourself through retirement, to send your children to an Ivy League college and to purchase a resort home on a tropical island. The most crucial goal is to ensure you don't run out of money during retirement. Thus, you want a high level of assurance that you'll reach that goal and will devote a substantial portion of your resources to achieve it. Your investments for that goal are likely to be conservative, especially as you approach retirement age.     The next important goal is to send your children to an Ivy League college. You have more limited resources to devote to that goal and your children can still attend a less expensive college or pay for part themselves if you can't save as much as needed. For that goal, you may be willing to assume more risk with your investments, to increase your chances of reaching that goal.     Your goal for a resort home is clearly last, so you may have few resources to devote to it. For that goal, you may be willing to use very aggressive investments because that may be the only chance of achieving the  goal.     The point is that your willingness to assume risk is not static. It varies depending on how important the goal is to you and how much you can designate for that goal. Commingling all your investments in one account for all your goals may make it difficult to analyze your investments in this manner. Thus, you might want to set up separate accounts for each goal, so you can more closely match the investments to your willingness to assume risk for that goal.

How you handle stock market fluctuations should provide a good indication of your emotional comfort level with risk. How do you react during periods of volatility? Do you take fluctuations in stride or have you been anxious about your portfolio's value? Have you frequently calculated your portfolio's value or only occasionally checked? Have you been tempted to sell all your stock investments or did you realize that this is just a normal part of the investing process? What would you do if the market sharply declined? How long could you withstand a declining market before feeling compelled to sell?

If you have difficulty handling market fluctuations, try to reduce your portfolio's risk to gain more comfort. Some strategies to consider include:

• Diversify your portfolio among several investment categories, including cash, bonds, and stocks, as well as within investment categories, such as owning several types of stocks. A properly diversified portfolio should contain a mix of asset types whose values have historically moved in different directions or in the same direction with different magnitudes. The theory is that when one asset class is declining, other assets may be increasing in value.
  
   

• Stay in the market through different market cycles. Remaining in the market over the long term helps to reduce the risk of receiving a lower return than expected, especially for more volatile investments, such as stocks.
  
   

• Become familiar with different investments and their risks. Over time, your comfort level with risk should increase as your understanding increases.
  
   

• Maintain reasonable return expectations. Otherwise, you may become disappointed if an asset does not perform as expected.
  
   

• Don't accumulate cash, waiting for a large sum to invest. Many investors feel it is less risky to invest smaller sums rather than one large amount.
  
   

• If you're not sure you can handle the risk associated with more aggressive investments, start out by investing a small amount. Increase your exposure as your comfort level increases.

Stock market volatility can serve as a check on how comfortable you are with your portfolio's risk.