If you’ve been learning about investing, you’ve probably heard countless times that you need to invest according to your risk tolerance.
Risk tolerance can be a difficult thing to figure out and there’s no point in hiding from that. But it is important, and that’s why we focus on it.
Measuring your risk tolerance is one of the harder things to do because it requires self-awareness and the ability to analyze your feelings without bias.
So let’s get into what risk tolerance is and how to measure it so that you can become a better investor.
What is Risk Tolerance?
Some people like to ski, but others can only imagine themselves eating a pile of snow.
Every activity carries some risk and your willingness to accept those risks is your risk tolerance, but understanding your risk tolerance can be a lot harder to figure out on your own.
Those of you who are more comfortable accepting a relatively great amount of risk are referred to as “risk tolerant.”
On the other end of the spectrum, those of you who accept very little risk are referred to as “risk averse.” Many people fall between the two ends of the spectrum.
Risk Tolerance in the Investment World
There are two forms of risk tolerance in investing: an investor’s capacity for risk, or ability to absorb losses; and, how comfortable an investor is with risk.
To get an idea of where you fall in the first category, ask yourself a simple question: how much money can I afford to lose? If you depend on your investments to pay daily expenses, you have less risk tolerance than someone who can see a loss as a mere disappointment.
The second form of risk has to do with your emotions and approach to uncertainty. To understand it you need to know your objectives and goals, life stage, personality, knowledge of investing, and investment experience.
Some investors will hang onto an investment during downturns in the market, while others will bail out at the first sign of trouble. You should only invest as much as you are comfortable with. If you find yourself losing sleep worrying about your investments, you may have invested too much or too aggressively.
Investors typically fall into three categories of risk tolerance: aggressive (those who are risk tolerant), conservative (those who are risk averse), or moderate (those who are somewhere in between).
Try to decide for yourself where you fall on this spectrum. This is important because it is one of the basic factors in determining the best investment strategy for you. It will affect both the types of investments you make and the way you choose to diversify your portfolio.
What is Investment Risk?
In investing risk means uncertainty, and refers to the possibility that you will lose your investment or that an investment will yield less than its anticipated return.
That uncertainty about the outcome means that investment risk also refers to the way the price fluctuates or changes in value from time to time, known as its price volatility.
The more the fluctuation in price and the shorter the time period, the higher the volatility. Generally, the more volatile your investments are the more uncertainty about the outcome, and therefore the greater the potential risk.
Three factors are key to understanding risk:
- Risk-return tradeoff – the observation that as risk increases, the potential for return increases.
- Historically, investments with greater risk have tended to provide higher returns, though past results are no guarantee of future returns.
- Investment planning time horizon – how long you plan to stay invested.
- The longer your time horizon, the more you may be able to afford to invest more aggressively, in higher-risk investments. This is because the longer you can remain invested, the more time you’ll have to ride out fluctuations in the hope of getting a greater reward in the future.
- Different types of risks exist – Each investment is subject to all of the general risks associated with that type
of investment.- Risk also arises from factors and circumstances specific to a particular company, industry, or class
of investments.
- Risk also arises from factors and circumstances specific to a particular company, industry, or class
The Role of Change
We change as we grow, and our risk tolerance can change too (though some authorities would disagree). Many factors can influence your risk tolerance at any given time and over any period. For example, it can change depending on family obligations or the state of the economy.
Be prepared to modify your investment plan should such changes occur.
How Can I Measure My Risk Tolerance?
Some tests measure risk tolerance, but they aren’t foolproof. We are talking about psychological behaviors that can vary under different conditions.
However, these tests are designed to give you a general sense of how much investment risk you can accept, and the results are generally considered reliable.
Generally, risk tolerance tests fall into two categories: investment preference tests and psychological tests.
Investment Preference Tests
This is a questionnaire that addresses preferences for selected investment vehicles. It asks questions about your current financial situation, goals, and past investment experience.
This type of test is easy to construct and relatively simple. The disadvantage, though, is that it does not accurately gauge risk-taking propensity because it does not deal with emotional reactions to risk.
Psychological Tests
This is a more elaborate questionnaire that attempts to gauge an investor’s attitude toward risk. This type of test generally includes questions about your feelings or behavior, or it may ask you to respond to hypothetical situations.
This method of testing is easy to administer and can be fun to take. The disadvantage is that people often like to consider themselves risk-takers and may not respond as accurately as they should, only to find out during their first market downturn that they are more risk-averse than they’d thought.
Risk Management and Your Retirement Savings Plan
Now that we’ve gone into what risk tolerance is and ways to measure it, let’s get into how you can expand on this knowledge and use it to create a standout retirement plan.
First, create a retirement savings plan. Doing so helps you manage one major financial risk: the chance that you will outlive your money.
Once you create your retirement savings plan, you need to manage risk within it so you stay on track. Here are some things to consider:
The Different Types of Risk
- Market Risk: The risk that your investment could lose value due to falling prices caused by outside forces, such as economic factors or political and national events (e.g. elections or natural disasters). Stocks are typically most susceptible to market risk, although bonds and other investments can be affected as well.
- Interest Rate Risk: The risk that an investment’s value will fall due to rising interest rates. This type of risk is most associated with bonds, as bond prices typically fall when interest rates rise, and vice versa. But often stocks also react to changing interest rates.
- Inflation Risk: The chance that your investments won’t keep pace with inflation, or the rising cost of living. Investing too conservatively may put your investment dollars at risk of losing their purchasing power.
- Liquidity Risk: This is the risk of not being able to quickly sell or cash in your investment if you need to access
the money. - Risks with International Markets: Currency fluctuations, political upheavals, unstable economies, and additional taxes – these are just some of the special risks associated with investing outside of the US.
Figure Out Your Emotional Risk Tolerance
How much risk are you willing to take to pursue your savings goal?
Gauging your emotional risk tolerance, which again is your ability to endure losses in your account due to swings in the market, is an important step in your risk management strategy.
Because all investments involve some level of risk, be aware of how much volatility you can comfortably withstand before you select investments.
Look at your plan’s investment materials and see if they have a quiz or other tool to help you gauge your risk tolerance. They often ask similar questions and can help you understand the investment strategy that will work best for your unique profile.
Diversify
Once you understand your risk tolerance, the next step is to develop an asset allocation mix that is suitable for your investment goal while fitting in the goldilocks zone of your risk tolerance.
Asset allocation is the process of dividing your investment dollars among the various asset categories offered in your plan, typically stocks, bonds, and cash/stable value investments. Generally, stocks are for more risk tolerant investors, and bonds are for the risk averse.
All investors, whether aggressive, conservative or somewhere in the middle, can potentially benefit from diversification, which is a big word that just means not putting all your eggs in one basket.
Diversification is often wise because holding a mix of different investments may help your portfolio balance out gains and losses. The principle is that when one investment loses value, another may be holding steady or gaining (although there are no guarantees).
Conclusion
Measuring your risk tolerance is a key part of learning to become a better investor and ensure a pleasant retirement.
But it’s only the beginning. Given how complex it is, it can help to have someone knowledgeable to advise you on the best path forward.
As experienced financial professionals, we help clients like you figure out the best retirement plan for their situation, so that when they’re ready, they can retire gracefully with peace of mind.
Please connect with us and let us help you plan for your dream retirement. We would be delighted to go on the journey with you.
