Investors are constantly keeping tabs on the market, but it’s just as essential to take stock of themselves. Knowing your risk tolerance can make the difference between a smart investor and a sorry investor. Relying on your risk tolerance keeps your trading actions in check and gives you a reliable strategy to fall back on when things get tough. But how do you determine your risk tolerance, and how can it help in the long run?
Here are some crucial details you may need to know about assessing your risk tolerance.
What is Risk Tolerance?
Simply put, risk tolerance is a measurement investors use to indicate how much risk they’re willing to take. This is different from a risk capacity which is the level of risk you are capable of taking on, depending on your financial circumstances.
Risk tolerance can possibly change throughout a person’s life. So, it would be best if you structured your portfolio to address those shifts as they come.
Why Is Your Risk Tolerance Important?
Investors who understand their risk tolerance are less likely to make impulsive choices. Investing and trading can be emotional for some. When we let those feelings get the best of us, we make rash decisions. That can ultimately hurt our finances in the future.
Prioritize objective assessments when you invest instead. If you remove the fear and anxiety from your process, you can focus on achieving your goals.
Types of Risk Tolerance
- Conservative Investors: A conservative investor prioritizes minimal risk. So, they pursue investments with lower returns in exchange for a consistent portfolio. They typically invest in low-risk instruments like government bonds and CDs (certificate of deposits).
- Moderate Investors: A moderate investment strategy is an on-the-nose description. It doesn’t play it as safe as the conservative investors, but it also doesn’t pursue the same level of high-risk investments as the aggressive investor. The moderate investor is looking for some level of risk to obtain higher returns. This category is where most investors sit.
- Aggressive Investors: Aggressive investors have the highest risk tolerance of the three. They’re also willing to accept the longest time horizon and the biggest swings in their portfolio, regardless of the direction. The goal is to earn higher returns, but it comes with trading in the more volatile products.
How to Determine Your Risk Tolerance
You can’t invest blindly or emotionally. You have to create specific standards to outline your risk tolerance and overall investment plans. Take into account factors like your current income, any dependents you may have, or other responsibilities. If others depend on you for financial security, you’ll have to accept a higher caution level when looking at the risk you can afford.
Make a Financial Plan
Prior to investing, you need to take an objective look at your situation. While you want to clearly see where you financially stand, you also want to use that information. Depending on your circumstances, you might have a particular goal in mind. These might be long-term milestones like paying for college or building up your retirement fund. Alternatively, you might want to generate just enough income to cover a shorter-term goal, such as a vacation.
Regardless, you can structure your plan to meet that eventual want or need. The longer-term goals may involve more risk, though. There are different ways you can cushion any losses, such as splitting up your investments or transitioning to lower-risk trades over time.
If you want a solid financial plan, you may want to speak with a financial professional. They can help you create a path that takes your personal situation into account and navigate the volatile market to find investments perfect for you.
Assess Your Comfort Zone
When it comes to investing, you can’t escape risk. That’s why you have to decide how much you are willing to take on. If you are only comfortable with low-risk investments, you will likely stay within the range of cash, CDs, bank accounts, and government bonds. Increasing that range of risk will lead you to moderately risky choices like stocks and mutual funds. Primarily, only those looking for that high-return, high-risk relationship will explore alternative and private company investments.
So, you investigate which option promises a reasonable return within the time horizon you have. For example, the low-return, low-risk tier is suitable for short-term investments. Therefore, if your goal is to save up for the future, you may not find this a sufficient opportunity. However, even with this group, it is possible to face loss. That possibility comes with every investment class.
Create a Diversified Portfolio that Suits Your Risk Tolerance
One of the greatest tools in your kit to minimize losses is a diversified portfolio. In particular, it’s important for those who have long-term financial goals and thus pursue higher-risk investments.
Diversification involves allocating your assets into different asset categories and unrelated products. As a result, you have a built-in counterbalance when disaster strikes. To explain, you are vulnerable when you only invest in one particular asset. If the market’s volatility affects that stock, there is nothing to lessen that loss. However, if your portfolio is varied, you’ll have other investments to buoy you.
Once again, you may have to shape your portfolio around your goals. Those with long-term financial goals need to implement enough risk to earn suitable returns. Your age should also play a factor in this. While young individuals may be able to invest with a little more risk, older groups should be wary. There is less time to bounce back from loss, so your diversification may need to be narrower.
Review and Rebalance
There are passive investors who may take advantage of personalized portfolios through their online broker. But even they should check in on that portfolio’s asset allocation. You want to ensure that you don’t rely heavily on a single category. Otherwise, you may run into the same problem as a non-diversified portfolio. All your success will depend on that single investment, which can run you into loss quickly if the market shifts. So, it’s important to rebalance your investments occasionally.
Some individuals base this on the calendar or the investments themselves. However, whether you rebalance on a regular or infrequent schedule is up to you and your investments’ performances.
The Bottom Line
Luckily, you don’t have to navigate the world of investing all on your own. If you are interested in investing, consider speaking to a financial planner. They can take inventory of your overall finances and help you craft a plan that helps you reach your goals, whether they’re long-term or short-term. When you work with a professional like a financial planner, you get curated advice that fits your situation, risk level, and more.