When you are investing, you are taking a risk of varying degrees. Risk tolerance is the amount that you, as the investor, are comfortable taking. It analyses an investors ability to endure potential money loss on an investment, which helps determine what type of investments they are likely comfortable making.
However, this can change throughout your life as an investor based on your financial standing and other outside influences. Risk tolerance is a vital component in investing. It allows you to have a realistic understanding of your willingness and ability to handle large swings in the value of your investments.
How Risk Tolerance Works
To gauge where you stand, you might want to seek the help of a financial planner or take a risk-related questionnaire. Accurately understanding how tolerant you are can be tricky, and both options can help you determine where you stand. A few factors that we will examine include if you’re concerned about losing purchasing power or money, how worried you will be if there is a severe market decline, what amount you are willing to lose, and how versatile you want your portfolio.
In general, you will want to determine which risk tolerance category you fit into, aggressive, moderate, or conservative. There is no right or wrong category to fit into.
How Is Risk Tolerance Calculated?
Determining your risk tolerance is generally done through questionnaires, either from your financial planner or online options. Some of the questions outlined above will be part of these questionnaires. A detailed risk tolerance questionnaire has up to 25 questions that focus on your perception of, reaction to, and choices you make to seek out risk.
The questionnaire provides you with a psychological measurement that will gauge your risk tolerance level. One of the most popular questionnaires is the FinaMetrica Risk Tolerance Profiling Questionnaire. This 25-question assessment will provide a scientific assessment of your personal financial risk tolerance.
While there are numerous questionnaires available to help guide you, the more questions you answer, the more accurate your results will be. It is recommended that for statistical accuracy you complete a questionnaire of at least 20 questions.
What Is A Risk Tolerance Example?
Risk tolerance will vary depending upon the category you fit into. A high-risk investor will have an aggressive risk tolerance. If you fit into this category, you will likely tolerate a potential loss of up to 50% to maximize potential gains.
On the flip side, a low-risk investor will have a conservative risk tolerance. If you fit into this category, as an investor you do not want to tolerate any potential loss. You will be searching for safer investment options, but willing to take smaller returns.
What Is Low Risk Tolerance?
If you have low risk tolerance, you favor investments that will maintain your original investment. While each investor has a different style of investing, a low risk tolerance investor typically checks their investment portfolio numerous times a day and will begin to panic with market downfalls. Lower-risk investments that come with lower returns will be more suited for someone who fits this category.
Does Risk Tolerance Decrease With Time?
Over time, you risk behaviors will differ. This not only is impacted by your age nearing retirement, but also on your financial ability to take on and handle financial shock. Young professionals with families have to consider savings for their children’s education, unexpected medical bills, and other financial goals, while also planning for their financial future. They might be risk tolerant in some ways, while conservative in others.
As your children leave the nest, you will likely be able to afford an increased level of risk. You will have to revisit the questionnaires to determine your updated tolerance level and long-term goals.
Then, ultimately as you reach retirement age, many investors tend to be less high-risk with their investments. Just because they can take higher risks does not mean that they should. As you age, many investors begin thinking about protecting their wealth through retirement and for their future generations, decreasing their risk tolerance.
Risk Tolerance Factors
Since everyone is different, there is no one-size-fits-all way to determine risk tolerance factors. However, you should review the following factors to determine where you stand.
While a common investment goal might seem like accumulating the biggest amount of money possible, it is not possible without taking a varying level of risk. Instead, determine what you want in life, calculate what you need to get there, and choose a strategy that will help get you to your goal milestones.
Investors are all different, with some being more naturally comfortable taking risk than others. When investing, you want to be sure you are able to sleep comfortably at night. If you’re staying up worrying about potential losses, you might be in too stressful of an investment strategy. Instead, you will want to consider less risky investments.
An 80-year-old’s tolerance will vary greatly from that of someone in their 20s and 30s. The younger you are as an investor, the more time you have to ride out higher risk investments.
Each investor has a different amount in their portfolio. Someone who has over $5 million will likely be more willing to take greater risks than someone with only $100,000. The larger the portfolio you have, the larger the cushion you have in case an investment drops.
Even if you are a younger investor, there might be a need for money in 5 to 10 years versus 20 to 30. After you determine your goals, examine the timeline that you would like to reach each milestone.
Risk Tolerance vs. Risk Capacity
When it comes to risk, tolerance and capacity are two greatly different things. Risk tolerance determines your psychological, or emotional, willingness to take risk. Risk capacity measures the ability of an investor to take risks, without endangering their financial goals.
You can have a higher risk capacity that could provide you with higher returns, however if you have a low risk tolerance you likely won’t want to take those riskier moves.
Criticisms Regarding Risk Tolerance
While this should play a large part in your financial planning, problems can rise if you misjudge your tolerance. If you make the mistake and believe you are ok being aggressive when you are moderate (or even conservative) you might make dramatic moves like selling stock, if the price falls significantly.
While most aggressive investors would do nothing during a decline and wait it out, you could make moves that would create a complete loss. But don’t worry, you can always go back to the drawing board to reevaluate.
While understanding your risk tolerance helps as a guide, controlling your behavior during unpredictability of investing will truly provide you with a realistic outlook to help make better investments in the future.
Downsides Of Ignoring Risk Tolerance
Without taking the time to understand where you stand, you are doing yourself a disservice. Set aside some time to dive into the questions that will help determine if you should play it safe or become more aggressive with your investing. This will help you reach your goals and help you see a difference over the course of your lifetime.
The most important thing to remember is to be honest with yourself when taking evaluating questionnaires. They will help you not be caught off guard if the value of your portfolio drops. After all, no one complains when the value rises, and while most wince when the market drops, being prepared for the stress can help you mentally prepare.
If you’re unsure of where to begin to determine your ideal level, reach out to your financial advisor. They can help guide you to investments that fit your lifestyle and help prepare you for how to handle situations if they get bumpy.