How to Determine Your Risk Tolerance for Investing
As an investor, you have many decisions to make. You have to decide what to invest in, when to buy, when to sell and much more.
Before making any of these decisions, you should start by building an investment plan. If it works, this plan will guide your investments to help you reach your financial goals.
The key to a successful investment strategy is being realistic. This includes knowing yourself and setting realistic goals. Knowing yourself is one of the biggest challenges.
In particular, you must understand your risk tolerance for investing before building an investment plan. Here’s what you need to know to figure that out.
What is Risk Tolerance?
Risk tolerance is the amount of risk you’re willing to accept to achieve returns with your investments. You can almost think of it as your comfort level of investing.
Each person’s risk tolerance is unique based on their mindset and investment choices.
It’s generally defined as a spectrum ranging from very conservative to very aggressive.
Your ability to handle risk
People with conservative risk tolerances prefer to avoid losses rather than get larger gains. Others with an aggressive risk tolerance can withstand losses, sometimes great losses, for the potential to have much larger gains.
It’s hard to determine a person’s individual risk tolerance, though. This is because it’s an abstract concept.
One way to approximate risk tolerance is to look at theoretical possible losses and gains. Investment firms usually show a theoretical gain and loss you could face in one year when trying to determine your risk tolerance.
An example could look like this for potential one-year periods:
- Maximum gain: 25%; Average gain: 12%; Maximum loss: 40%
- Maximum gain: 20%; Average gain: 8%; Maximum loss: 30%
- Maximum gain: 5%; Average gain: 3%; Maximum loss: 3%
In the example above, the most aggressive strategy is listed first and the most conservative approach is listed last.
Obviously, these are theoretical amounts and no future gains or losses can be projected. That said, actual returns of different investments could be used to show examples. The key is remembering past returns don’t guarantee future results.
Factors to Consider When Examining Risk Tolerance
When you’re examining your risk tolerance, it helps to look at your investment strategy as a whole. Your risk tolerance for one goal may differ from your risk tolerance for another.
As a young investor, you can generally take more significant risks. This is because you have more time to recover if your investments don’t perform as expected.
When you get older, your goals tend to be short-term to mid-term goals. These goals may not allow you to invest in high-risk investments that come with a lot of market volatility.
If your investments tank shortly before you need it for your goal, you may not have time to recover.
Investment time horizon
Even if you’re young, you may have a short-term investment goal. If that’s the case, you can’t afford to take as much risk as a 40-year goal may allow.
It’s essential to match your risk tolerance for each goal with the time horizon to meet that goal.
Your income could influence your risk tolerance decisions.
You may be willing to take more risks for smaller goals if you know you have a high income. This is because the high income could add additional funds should your investment not turn out as expected.
People with lower incomes may not be able to take as much risk.
If their investment fails, they may not have the income to supplement the investments they already made should they not work out as planned.
Other resources can play a role when looking at your risk tolerance. If you pay a financial advisor to help you, you may be able to consult them when feeling nervous about the markets.
Part of an advisor’s job is helping you make intelligent investment decisions. This includes not panic selling.
These other resources can assist you along your investment journey and may help you feel more comfortable taking on more risk than doing so independently.
How to Determine Your Risk Tolerance
Determining your risk tolerance can be tricky. Part of the exercise is mental, but the other part comes with the experience you gain over time.
Several websites have risk tolerance questionnaires you can fill out. These ask questions about how you feel about certain situations. Then, they share what they perceive your risk tolerance to be.
These services usually offer financial products with several different investment portfolios based on the risk tolerances they assess. Their goal is to get you invested in one of their products.
This works great in theory. That said, you won’t know how a theoretical loss feels until you actually experience it. If the loss is too much to bear, consider talking to an advisor about adjusting your risk tolerance.
Look at historical returns
Another way to assess risk tolerance is by looking at the historical returns of asset classes you’re considering.
Look at the maximum one-year gain and losses, average gains and losses over one year, and longer-term gains and losses. This can give you an idea of what types of investments may be suitable for you.
If you’d like a more personalized experience, you could consult a financial planner.
How Risk Tolerance Could Impact Your Investment Decisions
Risk tolerance can impact how you build your investment plan in several ways.
Diversifying your investments among several assets could help if you have a lower risk tolerance. Diversification is the process of putting money in several investments instead of just one. That way, if one underperforms, the others may outperform and offset the potential loss.
Ideally, you want to choose assets that don’t move in the same way at the same time.
For example, you wouldn’t want to pair a stock with a commodity if the stock increases when the commodity increases.
Asset allocation is the process of deciding where to put your investment money.
For instance, your asset allocation in your brokerage account could be split between stocks, bond, and alternative assets.
A short-term and conservative investor may decide to allocate 20% to stocks, 50% to bonds and 30% to certificates of deposit. They may do this through a mutual fund or buying individual investments.
However, an aggressive investor used to making risky investments may choose to allocate 75% of their assets in U.S. stocks and 25% in international stocks.
Buy and sell decisions
Risk tolerance plays a considerable role in your buy and sell decisions.
If you invest in stocks that are riskier than your risk tolerance, you may regret it. If the stock drops more than you’re comfortable with, you may end up selling and locking in losses.
If you invest in investments that match your risk tolerance, your investments won’t drop more than the amount you’re comfortable with in an ideal world. This would allow you to hold the investment and hopefully wait until the price recovers.
Risk Tolerance Can Change Over Time
Risk tolerance isn’t a set it and forget it concept. As you grow older and your financial life changes, your risk tolerance may also change.
It’s essential to regularly check your risk tolerance to see if it has changed. It wouldn’t hurt to check once a year, but even checking once every five years is better than not checking at all.
But why does risk tolerance change?
Your life situation changes.
When you first start investing, you may be young and single. At this time, you may be willing to take a higher risk.
When your risk tolerance might decrease
You may get married, have kids, and you’ll definitely grow older over time. This could cause you to become a more conservative investor.
As you have more people depending on you and your timeline gets shorter, you may not be willing to take as much risk anymore. This could lower your risk tolerance.
When your risk tolerance might increase
Let’s say you start investing early in life but stick to low-risk products, such as certificates of deposit, because you’re scared of the stock market.
You may decide to educate yourself about investing and suddenly feel more comfortable about investing in riskier assets.
You realize you need to set up safeguards, but this could unlock even more investment types with a higher risk tolerance.
Consult an Expert
Consulting a financial planning expert could be the right move before you start investing. This is especially true if you don’t feel you can be objective about determining your risk tolerance on your own.
When looking for a financial planner, you may want to choose a fee-only fiduciary financial planner.
These planners do not accept commissions. This means their advice won’t be conflicted by potentially earning money when they sell you particular investment products.
They’re required, as a fiduciary, to give you advice in your best interests, as well. Other advisors only have to provide suitable advice.
You will have to pay this type of advisor a fee based on the service provided or a time-based fee. But that fee may be worth the objective advice you need when determining your risk tolerance and setting up your financial plan for the first time.