Investing: What Is Your Risk Tolerance?
Whether you’re asking someone out on a date or contemplating a big career change, we all have moments when we have to decide whether the risk is worth the reward.
Whenever you put money into an investment product, whether that be stocks, bonds, real estate or even gold, you’re taking on a certain amount of risk. Whether the potential reward – making money – is worth that risk depends on your own personal level of risk tolerance.
What Is Risk Tolerance?
In the investing world, risk tolerance refers to how much risk you’re willing to take on when it comes to your investment strategy and how comfortable you are potentially seeing the value of your investment take a hit. Not all investment products are equal, and some types of investments experience more volatility than others.
Think of risk tolerance as a spectrum.
On one end are aggressive investors. They have a high tolerance for risk and tend to choose investments that provide lots of opportunity for growth – but also plenty of opportunity to lose money. High risk, high reward.
On the opposite end of the spectrum are conservative investors. These investors have a low tolerance for risk and as such seek out investments that likely won’t see as much growth but tend to be less likely to lose money. Low risk, but also low reward.
In the middle are moderate investors, who are OK with taking on a modest amount of risk. Their investment portfolios often include a mix of a variety of different types of investments with different levels of risk that keep their overall level of volatility fairly mild.
Why Is Risk Tolerance Important?
Knowing your level of risk tolerance is important because it helps determine what your strategy should be for your entire investment portfolio, including any retirement assets you have.
Knowing your risk tolerance helps you pick a strategy you’ll realistically stick to. You want to avoid investing more aggressively than you’re comfortable with, because you’re more likely to make decisions based on fear, which can end up hurting your growth.
For example, if you begin investing aggressively and put all your money into higher-risk investments, but get scared when the market takes a dip and pull all your money out of the market right when it’s at its lowest point, you’re not only giving up the money you’ve already lost, but you’re also missing out on the potential future gains when the market swings back up again.
Though aggressive investors may see their investments decrease in value from time to time, especially during a market correction or recession, by keeping those investments in the market and even putting more money in while the market is at a low point, they’re betting that they’ll get that money back and then some when the market recovers. However, this strategy only works if you’re willing to ride out the low points and see your assets go down in value.
Not everybody can do this, and just because you feel confident when the market is doing well doesn’t mean you won’t have an understandable emotional response to losing money and do something rash that could cost you in the long run.
By honestly evaluating what you find to be an acceptable amount of risk and being realistic about how much you stand to gain or lose, you’ll be less likely to make decisions out of fear that go against your long-term strategy, potentially costing you more than sticking with your original strategy or picking a more conservative strategy would have.
What Factors Affect Risk Tolerance?
Aside from your personal feelings about and reactions to market volatility, one of the biggest factors in determining an individual’s risk tolerance is their time horizon.
Time horizon is the amount of time you expect to keep your money in the market. This will often be determined by your age, as well as what your goals are for your money.
Many people use investments to help fund their retirement. For long-term goals like this, you typically have a longer time horizon than if you were investing for a more medium-term goal, such as saving for your child’s college tuition.
Young people just starting out in their careers have longer time horizons for their retirement goals than those who have been in the workforce for a couple decades.
What does this have to do with risk tolerance? The closer you are to reaching the end of your time horizon, the more conservative you should be with your investments. If you have a very long time horizon, your investments have more time to weather the ups and downs of the market. As you approach your goal, you have less and less time to recover if your investments were to take a hit.
When it comes to investing for retirement, for example, young people are typically advised to have more aggressive portfolios. As you get older and closer to retirement, you may find that it makes more sense to start moving your money into more conservative, less risky investments.
Putting your money into investments allows it to grow and keep up with inflation better than if you kept it in a basic savings account. The trade-off is that you risk losing money on an investment, especially in the short term.
This is why investing isn’t typically recommended for short-term goals such as saving for a car or a down payment on a house. If your investments lose value right before you need that money, you won’t have the time to wait for the market to build that value back up.
Again, while your time horizon is a big factor in determining what your general level of risk tolerance should be, it’s important to also make sure you’re investing within your own comfort level.
Low-Risk Investments Vs. High-Risk Investments
How do you choose investments that match your risk tolerance?
If you work with a financial advisor who specializes in investments or a brokerage company that manages your portfolio for you, you’ll get personalized recommendations that are based on your risk tolerance, goals and time horizon.
When people think about the relative risk of certain investments, they often think of stocks versus bonds.
Investing in stocks tends to be viewed as riskier, offering higher potential returns but also more volatility. Bonds are often viewed as more reliable and less volatile, while offering more moderate returns.
Your risk tolerance will determine the allocation of different types of assets within your portfolio.
For example, someone with a higher tolerance for risk might have a portfolio allocation with 80% in stocks and 20% in bonds, while someone with low risk tolerance might opt to put more money in bonds and less in stocks.
Though stocks and bonds are the asset classes that people most associate with investing, there are other asset classes available for investors that offer varying levels of risk and returns.
On the low end of the risk spectrum are products like certificates of deposit. These accounts function more like savings accounts, but typically offer higher interest rates than what you’d get with a traditional savings account. The trade-off is these accounts come with rules specifying when you can withdraw funds and what the penalties are for early withdrawals.
The high end of the risk spectrum includes things like collectibles and commodities. These types of assets tend to experience a lot of volatility, which makes them risky for investors. Commodities that you can invest in include things like metals or oil. Collectibles are things like art and antiques.
What Is My Risk Tolerance?
So, what’s your own personal level of risk tolerance? There’s no right or wrong answer. It has to do with your level of comfort with risk and how long you have to wait out the ups and downs of the economy.
When deciding on your investment plans, keep in mind that if you choose a strategy that’s too conservative, you might miss out on some significant returns, while if you choose one that’s too aggressive, you could end up losing the money you’ve invested.
Your risk tolerance won’t be the same for every goal and every stage of your life.
For long-term goals like retirement, be sure to remain proactive and consult with your portfolio advisor about moving your money to less-risky investments as you get closer to the end of your time horizon.
Want to learn more about how to manage your financial profile? Check out Rocket HQSM’s Personal Finances Learning Center.
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