Determining your risk tolerance is an important part of laying out an investment plan as it helps keep you invested and moving toward your goal, even as markets invariably test your financial and psychological fortitude. Risk tolerance is a guide for choosing an asset allocation – the proportions of money invested in different assets that give your portfolio a risk level you’re comfortable with and expected returns to reach your target.
First off, what is risk tolerance?
Risk tolerance is the amount of variability when it comes to your investment returns that you as an investor can withstand. It is one of the many important concepts in investing. When it comes to risk tolerance, it is important that you set a realistic gauge that you can tolerate.
Determining Risk Tolerance
Risk tolerance is a subject matter that is often discussed but rarely defined. It is not unusual to read a trade recommendation discussing alternatives or options based on different risk tolerances. But how does an individual investor determine his or her risk tolerance? How can understanding this concept help investors in diversifying their portfolios?
An often seen cliché is that of what we’ll refer to as “age-based” risk tolerance. It is conventional wisdom that a younger investor has a long-term time horizon in terms of the need for investments and can take more risk. Following this logic, an older individual has a short investment horizon, especially once that individual is retired, and would have low-risk tolerance. While this may be generally true, there are certainly a number of other considerations that come into play.
First, you need to consider investment. When will funds be needed? If the time horizon is relatively short, risk tolerance should shift to be more conservative. For long-term investments, there is room for more aggressive investing. However, be careful about carelessly following conventional wisdom.
Net worth and available risk capital should be important considerations when determining risk tolerance. Net worth is simply your assets minus your liabilities. Risk capital is money available to invest or trade that will not affect your lifestyle if lost. It should be defined as liquid capital or capital that can easily be converted into cash.
Therefore, an investor or trader with a high net worth can assume more risk. The smaller the percentage of your overall net worth the investment or trade makes up, the more aggressive the risk tolerance can be.
Your investment objectives must also be considered when calculating how much risk can be assumed. If you are saving for a child’s college education or your retirement, how much risk do you really want to take with those funds? On the other hand, you can take more risk if you are using true risk capital or disposable income to try to earn extra income.
See Also: How to Increase Retirement Income?
When it comes to determining your risk tolerance, your level of investing experience must also be considered. Are you new to investing and trading? Have you been doing this for some time, but are branching into a new area, like selling options? It is wise to begin new ventures with some degree of caution, and trading or investing is no different. Get some experience under your belt before committing too much capital.
When determining the answer to a seemingly simple question, “What is my risk tolerance?” The answer will vary based on your age, experience, net worth, risk capital and the actual investment or trade being considered. Once you have thought this through, you will be able to apply this knowledge to a balanced and diversified program of investing and trading.
Spreading your risk around, even if it is all high risk, decreases your overall exposure to any single investment or trade. With appropriate diversification, the probability of total loss is greatly reduced. This comes back to preservation of capital.
Knowing your risk tolerance goes far beyond being able to sleep at night or stressing over your trades. It is a complex process of analyzing your personal financial situation and balancing it against your goals and objectives. Finally, knowing your risk tolerance, and keeping to investments that fit within it, should keep you from complete financial ruin.
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