There are two universal truths in investing:
every investment inherently comes with a certain level of risk and every investor has a different tendency for it.
How much of that risk will turn into rewards depends greatly on your investment risk tolerance. It’s one of the fundamental tenets of every investment strategy that determines how much any investment will be exposed to risk and the investor’s ability to withstand the potential loss of money on an investment.
In other words: investment risk tolerance is a fancy way of saying how much loss you are willing to accept if/when your investment (or more of them) performs below standard.
To determine investment risk tolerance, begin by accepting the general rule of thumb: the greater the potential reward, the greater the risk is. The opposite doesn’t hold true because greater risk doesn’t automatically lead to greater potential reward. Figuring out your investment risk tolerance levels begins with understanding key investment risk factors that can completely change your risk tolerance outlook down the road. Consider them as the most important questions you need to ask yourself before you do anything else.
What is your objective?
Smart investing starts with an outline of your goals. Whether it’s personal or financial, having a clearly defined objective makes it easier to decide when and where to invest. Other factors, such as time, will greatly influence your investment objective vs risk tolerance ratio.
If you’re thinking short-term such as saving to buy a new car or house next year, the logical option would be low-risk investments such as high-interest savings accounts and bonds (which are technically not investment, alas) or money market funds. You’re not looking for a robust return and want to have a little bit of money in your pocket “just in case”. In the long run (e.g. saving for your kids’ college tuition or retirement), you can have a high-risk tolerance investment and aim for investments that will yield a higher return because you have the benefit of waiting for the value to increase if it ever drops and you’re not seeking immediate returns.
Do you have the time?
Time is a fickle thing. In this instance, I am talking about age. Investment risk tolerance changes over time together with your financial standing. When you’re young, you have the luxury to wait out and survive the market fluctuations (sudden downturns are common in this line of business) so you can afford to be aggressive with your investments. There are also fewer responsibilities like family to factor in your decisions.
The older you get though, there is less time to accumulate wealth. You begin to think about long-term financial security and retirement, where investors typically opt for lower risk tolerance and focus on more stable investments.
What is your net worth?
An obvious factor but still worth mentioning because net worth is a measure of your financial health. It’s an amalgamation of your assets (what you own – cash, real estate, cars, etc.) and liabilities (what you owe on those assets – car loan, mortgage, etc.) or essentially, what you would have left if you sold all of your assets to pay off all of your liabilities. A high net worth enables a higher risk tolerance and the other way around. However, it isn’t exclusive – you can also be conservative and play it safe even if you aren’t strapped for cash and vice versa. There are no rules to which you have to play.
What is your level of knowledge and experience?
For those who are just starting out, it may be smart to ease into the investing world and take it slow. Exercise caution if you think you aren’t ready to manage a loss on your investment. Take on low-risk investments (even if they don’t yield high returns) before you get familiar and comfortable with market swings and finer details of the game. It’s important to soak up knowledge so you can envision the worst-case scenario and be prepared to take the risk.
Can you emotionally accept the risk?
Not everyone is able to cope psychologically with the idea of losing money or see potential investments objectively sometimes. If personal comfort level is exceeded, judgment can be easily clouded. Some investors are more comfortable with risk-taking than others who can become overly anxious, for instance, when it comes to the possibility of losing money – even if there is enough time for the investment to recover.
As such, the emotional factor largely determines what type of investments you will or won’t make, as well as highlights the importance of having a sound goal-driven framework that allows you to consciously accept the risks that correspond with it.
Drawing the line
Those would be the investment risk tolerance questions you need to answer before you invest in anything. As you can see, you can keep some of these factors under control while some will be beyond your grasp. There is nothing else to do but control the ones you can and use your best judgment to manage the others.
Understanding investment risk tolerance helps create a plan on which you can build your investing style:
or a combination of some of those four. It’s a complex process that only you can find an answer for by assessing your financial and emotional situation and balancing it against your goals, time horizon, and expertise.
Investment objectives and risk tolerance constantly tangle with each other so there is a lot to consider. Don’t let that deter you from investing, though. Risk isn’t so scary when you get to know its types and ways to manage it. Keep your objectives in mind and don’t be afraid to adjust your portfolio if things don’t go as planned. You can always get some professional advice from a financial adviser to relieve your concerns.
Remember: what you don’t know about investing might cost you dearly one day.
P.S. There are quite a few investment risk tolerance calculators online so you might want to try them too for a quick assessment, if only for fun.