As you begin investing, take some time to get to know yourself. Understanding your risk tolerance can help you make better decisions for your portfolio. If you plan to have a role in building your wealth through investment, you need to know your risk tolerance.
Financial Risk Tolerance
When most of us think of risk tolerance as it relates to investing, financial risk tolerance is what comes to mind. Financial risk tolerance is all about the hard numbers: How much money can you afford to lose?
Your financial risk tolerance includes your total financial situation. Some of the items to consider include:
- Can you afford the amount you are locking up for a certain period of time?
- What happens if there is a market crash just before you need the money?
- Could your finances survive if one of your investments loses big?
- Is there enough diversity in your portfolio to prevent a complete meltdown?
- How soon will you need the money?
Use your financial risk tolerance to determine your asset allocation. If you have a low financial risk tolerance, your asset allocation will be weighted toward cash and bonds. However, if you can afford to take a loss, or if you have time to make up losses, your allocation will likely include riskier assets, such as stocks or maybe even commodities.
Look at your entire financial situation and evaluate what you can handle in terms of your investment. Consider your portfolio and the investments you plan to make in terms of a worst-case scenario. Remember that you might not be able to access some of your money for years (especially if you’re investing in a tax-advantaged account), and that when you do have access, it might be during a down market.
Create a plan B, and prepare for the future. Know the realities of your financial situation, and your timeline, before you invest.
Emotional Risk Tolerance
Rather than focusing on the numbers related to your situation, emotional risk tolerance is about how much you can stomach. Are you influenced by every little change in the market? If so, your anxieties and low risk tolerance may prompt you to trade a little too often, or make trades based on fear. This can negatively impact your portfolio as you sell low in a panic or see your returns eroded by transaction fees.
On the plus side, lower risk tolerance can lead to solid, well thought out investments. These investments can provide you with a safety net and limit losses in a portfolio. Unfortunately, an overly cautious approach to investing can mean that gains come too slowly; inflation can be a real problem if your investments are so conservative that gains can’t keep up with declining purchasing power.
Opposite of low emotional risk tolerance is the tendency to enjoy risk. Some investors with a higher emotional risk tolerance are more comfortable with riskier assets. Over time, higher risk investments have the potential to offer greater returns than lower risk investments. However, there is also the chance that the higher risk will result in larger losses.
Evaluating your emotional risk tolerance is more about understanding your personal style and recognizing your weaknesses. Once you know your emotional risk tolerance and how it affects your investment choices, you can work to offset your tendencies. While you don’t want to do something too far out of your comfort zone, a little balance can work to your advantage.
A comprehensive understanding of your risk tolerance – both the financial and emotional aspects – can help you recognize areas for improvement, creating strategies that can help you reach your financial goals.