Investing: What is Your Risk Tolerance?
When it comes to investing, everyone has a certain level of risk they can stomach. For instance, if you invest in the stock market and it drops a little, you may be ok with it.
But if it drops a lot, you may be more likely to want to sell. If this sounds like you, you’re probably a more conservative investor.
And if you’re new to investing, you want to understand risk tolerance and know how much risk you’re willing to take on. This knowledge will help you come up with the right investment strategy going forward.
What is Risk Tolerance?
Risk tolerance is commonly understood as a measure of one's financial ability to withstand losses. When it comes to risk tolerance, most investors fall into one of the following three categories:
1. Conservative Investors
A conservative investor is someone who will tolerate minimal risk when it comes to their investments. They will often prefer low-risk investments like bonds or certificates of deposit.
2. Moderate Investors
A moderate investor is someone who takes on a mix of low-risk and higher-risk investments. For instance, they may invest in mutual funds, which come with a little more volatility. But they may balance this risk by investing in bonds as well.
3. Aggressive Investors
An aggressive investor can stomach a high level of uncertainty. They may have some low-risk investments, but overall, seek those that are high-risk, high-reward.
Why is Risk Tolerance Important?
Risk tolerance is how much uncertainty you’re willing to take on when it comes to your financial investments. This is important because there is an inherent level of risk involved in any type of investment.
However, some investments will be more high-risk than others. For instance, a U.S. Treasury bond is generally considered a low-risk investment. By comparison, investing in the stock market is riskier because there is more volatility.
Understanding your risk tolerance is one of the most important elements of investing. It’s what’s going to drive your investment strategy and determine the health of your portfolio.
For instance, if you’re a very conservative investor, it’s not a great idea for you to invest all your money in high-risk stocks. That’s because the minute the market goes down, you’ll likely get spooked and want to pull your money out immediately.
That being said, there are risks to playing it too safe with investing. If you invest very conservatively, you’re not going to reap the same rewards and may find that you’re unable to reach your goals.
What Factors Influence Risk Tolerance?
There isn’t one correct answer when determining how much risk you should take on. Depending on your financial situation, income and various other factors, it may make sense for you to take a conservative investor approach.
Let’s look at four factors that will influence your level of risk tolerance:
1. Your Investment Timeline
If you have time on your side, you may be able to afford to be a more aggressive investor. If you’re thinking about what your investments will earn over the next 20 years, then you can afford to withstand occasional dips in the market.
However, if you’re looking to retire in the next 5 years, this is an entirely different situation. You probably don’t want to take any big risks that could jeopardize the principal of your investment.
2. Your Future Earning Capacity
If you’re in your 20s or 30s, your future earning capacity is considerably higher than someone who’s nearing retirement age. Therefore, you can afford more risk and have a more aggressive investor tolerance.
Or if you’re growing your business and your income is more uncertain, you may not feel comfortable with a high level of risk.
3. The Size of Your Portfolio
If you have a sizeable portfolio, you can afford to take more risks than someone with a smaller portfolio. Someone who has an investment portfolio with millions of dollars will be better able to withstand losses than someone who has $100,000 in theirs.
And if you have other assets, like a home, Social Security or a pension, you may also be willing to withstand more investment risk.
4. What You're Comfortable With
Ultimately, it doesn’t matter how well you're doing financially or how long you have until retirement. If you’re not comfortable being an aggressive investor, it’s probably not going to be the right choice for you.
Your investing strategy is meant to give you peace of mind. So if you’re constantly stressed and worried about dips in the marketplace, this is probably a sign you need more low-risk investments.
How to Assess Risk Tolerance
As mentioned, risk tolerance is your ability to withstand the ups and downs that come with investing. All investments come with some level of risk, but some are riskier than others.
It’s a good idea to know what type of investor you are right from the start. This information will help you create the strategy that’s right for you.
If you’re wondering how to assess what kind of investor you are, here are a few questions you can consider:
- Are you resistant to the idea of losing any money?
- Do you need to keep your investments mostly liquid?
- Do you wonder what are the risks of playing in the stock market?
- Are you drawn mostly to low-risk stocks and safer investments?
These questions will help you begin to determine the right investment strategy for you. For more information on this topic, feel free to check out our Personal Finance Resource Center.
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