What is Risk Tolerance and How Do You Determine Your Own?
Thinking about risk in investing can elicit a number of emotions. Does it mean the opportunity for great returns? Or does it bring up thoughts of being left with nothing? Or to you is investment risk not exciting at all, just an inevitable part of the investment process?
Asking these types of questions can help you better understand what your risk tolerance is. How would you react if you were to have a significant loss? Could you weather the storm?
Defining Risk Tolerance
Risk tolerance is a measure of how much risk an investor can emotionally handle. It is based upon the investor’s examination of just how big their appetite for risk is – which can be tricky to figure out. Sometimes it can be hard to figure out how much you can emotionally stand to lose in a market dip until you’re smack in the middle of one. You may not know your comfort level with uncertainty until you are faced with a loss. Self-analysis about your attitude towards risk is important to do before you begin investing.
Determining Your Time Horizon
Possibly the most important factor in determining your risk tolerance is your investment time horizon, or how long you plan to keep the money invested. The sooner you need the money, the more conservative your risk tolerance will be, as stocks behave much more volatilely in the short term. If you need your money quickly, it’s risky putting it into a portfolio that is heavy on stocks. Conversely, if you’re investing for the long term, you can “afford” more risk because you will have more time to recover from a loss. In fact, if investing for the long term, it can actually be detrimental to keep your money in cash as inflation will “erode” its value.
Asses Your Other Ways to Make Income
Your risk tolerance is also dependent on what your other income streams are and how stable they will be. Someone with a secure job and steady pay can afford to take on more risk because their investments aren’t their primary source of income. Those who own their own small business or who are unemployed may want to consider a more conservative approach.
Translating Your Risk Tolerance into an Investment Strategy
Once you know how much risk you can take on, you can work with an advisor to find the right portfolio for your investments. If you know the typical performance of model portfolios like your own, you will likely be more prepared for the possible ups and downs. For those with low risk tolerance, a conservative portfolio of 30% stocks and 70% bonds might be the way to go, while more aggressive investors could be best suited for an 80% stock, 20% bond portfolio. A good financial advisor will help guide you in the right direction.
At Walsh & Associates, we help our clients understand their risk tolerance to provide a portfolio that fits their emotional limits and financial needs. By understanding your risk tolerance and personal circumstances, you’re that much closer to achieving your financial goals.