Most investors know that risk and return go together.
Generally, lower returns mean lower risk and vice versa. When it comes to acceptable levels of investment risk tolerance however, everyone is different.
So, what is risk tolerance, exactly? Generally, it’s how much risk you’re willing to take to reach your investment goals. This typically depends on several factors, so it’s really important to establish your own risk tolerance before you start investing.
While they can certainly be broken down further, and it is possible to be in more than one category, the three main categories of risk tolerance are:
Conservative—Conservative investors’ key concern is keeping hold of their capital. It is more important to them to avoid losing money than making it. For this reason, they usually invest in assets that typically ensure a return of principal, such as GICs and bonds.
Moderate—Investors with a moderate investment risk tolerance strike a balance between growing their money and protecting it. They will take on some risk but will temper it with the amount of loss they are willing to accept.
Moderate—Risk investors will typically hold some higher-risk assets, such as equities, as well as safer investments like bonds. They will usually earn more in rising markets than conservative investors but lose less than aggressive investors when the market falls.
Aggressive—The ups and downs of the stock market are all part of the process for this type of investor. Investors with an aggressive investment risk tolerance prefer asset classes with the potential for high growth, such as equities.
This can lead to higher returns when the market is doing well but the downside is that they will experience greater losses when markets dip. Market crashes don’t affect their investment goals, however: they are used to these fluctuations and know that it pays to stay the course. They also see market dips as an opportunity to buy equities at a discount.
So which one are you?
To figure out where you are on the risk-reward investment scale, you need to go through an investment risk assessment, so you know your personal investment risk tolerance level. Risk is very subjective. For some investors, losing a few thousand dollars is small change, while for others, dropping even a couple of hundred dollars is a big deal.
Below is an example of a risk tolerance questionnaire. By answering these six questions, you’ll be able to better gauge your personal risk tolerance level:
1) Do you understand the market? One thing to consider is your market knowledge. If alpha and beta are all Greek to you, it’s probably wise to wade in slowly. If your nest egg is small, the payoff for taking on risk would not be that significant, so it makes sense to take it slowly until you grow your confidence and understanding.
2) How old are you and what is your investing time frame? On the whole, the longer you intend to hold onto your investments, the greater the risks you can take. If your financial plan means you need a certain sum of money in 30 years’ time, you can take greater risks (and aim to grow your money faster) than if you needed that money in two years’ time. The market has always grown over the long term, but it can take it a year or more to fully recover from some dips.
3) What are your investment goals? Everyone has different financial goals, and this should have a bearing on how much risk you need to take on. If you want to reach $1 million in investments by the time you retire in 30 years, then you can — and probably should — take on greater risk than someone who needs to save $10,000 in two years. A good financial plan will determine how much you’ll need to invest, over a set time period, with a risk tolerance level that will help you to reach that goal.
4) Have you experienced investment losses before? If you’ve been through a market slump, think about how it made you feel. Did it cause you to pull out of your investments and sit on the sidelines or move into safer investments? Did it cause you emotional stress or were you able to stick to your plan, knowing that your investments’ value would eventually recover? Answering these questions will give you a good read on your risk tolerance.
5) Do you have other money to fall back on? If you have significant income or other investments (such as real estate or a trust fund), taking on high risk could be more of an option. However, if you depend on your investment dollars to live, your risk tolerance should be lower.
6) Do you know how much you could lose? It can be harder to evaluate how much of decline in investments you can stomach when you think about potential losses in percentage terms. Dollar terms can make it more concrete: instead of a 30% drop, tell yourself that it’s a $30,000 drop. How would that make you feel?
Once you’ve figured out your investment risk tolerance, you need to identify ways to maximize the potential for higher returns in your investment portfolio, while also staying inside of this tolerance zone.
Markets fluctuate, but studies have proved that investing over time delivers much higher returns than dipping in and out of the market. Spread out the risk by diversifying your portfolio and using asset allocation so your portfolio contains a mix of investments that best suits your goals and risk tolerance.
This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.