Risk tolerance is not something that should be overlooked when you begin investing. Your tolerance level gauges your ability to withstand losses if your investments perform poorly, or if there is a drop in the market. It can change over the course of your life however. Your strategy should be adjusted if you are too stressed by your existing investment risks.
To understand your risk tolerance, you will need to dive into your behavioral tendencies and provide an honest answer to questions about how comfortable you are with the risk of each investment. Once you understand your personal risk tolerance, you can design a portfolio that bears your tolerance in mind.
Your Risk Tolerance Preference
There are three preferences that can help determine your investment strategy – conservative, moderate, and aggressive. There is no right or wrong tolerance for risk, it is 100% personal. Some that hear “risk” when talking about finances can make their stomach turn, while others might get a thrill for the opportunity. Both are completely understandable for their unique tolerance type.
Conservative Risk Tolerance
If you are a conservative investor you likely value protecting your principal over higher payouts. You will be comfortable accepting these lower returns to protect your financial stability.
Although this investment strategy comes with little risk, there is also little reward. Many conservative investing strategies preserve your nest egg and will keep your portfolio free from large losses. Older investors tend to switch to this investment style to maximize their income with lower risk during retirement.
People with conservative risk tolerance preferences will invest in safe, short-term investments such as certificates of deposit (CDs) and Treasury bills.
Moderate Risk Tolerance
If you are a moderate investor, you likely value reducing your risks while enhancing your rewards. You will be comfortable taking a modest risk to see higher long-term payouts and are comfortable taking a short-term loss of your principal investment in exchange for the long-term value.
Moderate investors typically look at an intermediate term with their investing, usually a five-to-ten-year approach. If you invest moderately, you typically invest your portfolio into a 50/50 structure. Half of your investing will likely go to less volatile bonds and less risky securities. The other half, meanwhile, will go to a portfolio to focus on financial growth.
Aggressive Risk Tolerance
If you are an aggressive investor, you will likely be comfortable doing whatever it takes to maximize your returns, including the acceptance of a potential substantial loss. You’ll value your long-term returns over protecting your principal and are not too concerned with market volatility.
Aggressive risk tolerance investors tend to be very market-savvy. They have a thorough understanding of securities and purchase high volatile instruments (like small-company stocks) that can have aggressive returns but with maximum risk.
What Does Risk Tolerance Affect?
When you are considering an investment, understanding your risk tolerance can provide you with peace of mind that you are taking strategic moves that make sense for you.
Risk tolerance affects many things. The first is your investment timeframe. If you are a younger investor, you likely have a long-term timeframe in mind allowing you the flexibility to take greater risks.
It is also impacted by your investing experience. If you are new to investing, you might dip your toes in the water with caution. Established investors will be more willing to take those higher risks and throw caution to the wind.
But again, there’s no right or wrong here. Your investment objectives are yours, and each person’s risk tolerance will affect them in their own personal ways.
When you’re considering the safest place for your money, your risk tolerance might vary depending upon your needs. If you are saving for retirement and you are young, a more aggressive savings strategy might be the way to go.
However, if you are looking for a place to keep your money safe with no risk of losing your principal, you will want to adjust your investment strategy for a more conservative approach. This is a fantastic place to keep your money safe. However, it is not a long-term investment strategy for maximum growth.
There are numerous ways to invest, and your risk tolerance affects your ability to withstand any losses that might come from them. Your short- and long-term investing goals should be taken into consideration when you are determining your risk tolerance.
Before you begin investing, think of how you would feel if the value dropped substantially overnight. If this danger is too much, you should consider a less aggressive investing approach. If this excites you, you likely view it as an opportunity to buy because the prices have dropped – making you a bit more aggressive risk taker.
One thing to consider when you are investing is if you are playing it too safe. If you are taking zero risks, will you actually reach your goals? Consider looking at investment returns and diversifying your portfolio. This ensures you are hitting your targets while still respecting your risk tolerance.
Depending upon your risk tolerance, your asset allocation for diversification will vary across the board.
If you’re on the conservative side, you’ll likely invest minimally in foreign stock and US stock. You may be more inclined to focus more on short-term investments and bonds.
Being on the moderate side will make your portfolio a bit more diverse. You will be more willing to take risks, while still making stable investments as a priority.
If you are an aggressive investor, you will have a much more aggressive portfolio diversification that is focused on growth. Your diversification will likely be the complete opposite of a conservative investor.
Understanding Your Risk Capacity
Your risk capacity is different from your risk tolerance. Risk tolerance is how comfortable you are personally in terms of unpredictability with your investments. Unlike risk tolerance, risk capacity is what level is needed for you to reach your financial goals.
Risk capacity considers the rate of return required to hit the necessary targets within your ideal time frame.
Taking Risk Seriously
As an investor, you should always gauge the risk of each investment before you make the decision. Taking careful consideration into understanding your risk tolerance will help prepare you for low returns, high returns, and potential losses.
Balancing and diversifying your investing will give you peace of mind. Even as a high-risk investor, diversification can decrease your overall exposure if a single investment goes south.
The bottom line when it comes to risk tolerance is to make sure you are investing in a way that allows you to sleep at night. If you are too overwhelmed with the idea of losses, you should drop down a level with your risk tolerance.
Protect Your Peace Of Mind With The Right Strategy
There is no right or wrong risk tolerance. It is a personal process to determine your unique financial situation and balance it with your goals and objectives. Knowing your risk tolerance should help you with your portfolio and strategies to keep your mind at ease.
If you are unsure of where to begin with a financial strategy that fits your risk level, consider reaching out to a financial advisor. They can provide tools to help assess how risky your choices are. Advisors provide solutions to help you reach your goal keeping your tolerance in mind.