In this article we’ll look at investment risk tolerance. We’ll explain what risk is, and help you learn a bit about your risk tolerance. We’ll talk about how risk is related to different aspects of your life. And finally, we’ll look at how to manage investment risk while striving for the best returns.
Do you eat food? Do you ever cross the street? Have you taken a bath in the last 10 years? If you answered yes to any of those questions, you’re a risk taker.
Maybe you don’t think of yourself that way, but it’s true. As your nervous grandma may have warned you, all those things involve risk. You could choke on your spaghetti; you could get hit by a car; you could drown in your bathtub. (It does happen.)
The sad truth is that just about everything we do has some degree of risk. And that includes investing.
So what exactly is risk? In simple terms, it’s the likelihood of a bad outcome. When it comes to eating food, you can’t avoid it—just remember to chew and you should be OK.
But when it comes to more “optional” activities, you can avoid risk. It’s actually remarkably easy to go through life without wrestling alligators or windsurfing near Niagara Falls.
In personal finance, risk is defined as the likelihood of your investment losing value.
In general, the higher the expected return on an investment, the higher the risk. Investing in an unproven new technology could make you a millionaire; but it could also lose you all your money if the technology fails.
And even safer investments, like buying an established stock, can lose money. After all, General Motors is a well-established company in an old industry with a proven market. But that didn’t stop it from going bankrupt in 2009.
And that can happen to any company. Products can fail. Markets can dry up. In investing, the future is never guaranteed.
The key point to remember about risk, then, is that some level of it is unavoidable. Even if you keep all your money stuffed under your mattress, you’re still running a risk—inflation will eat away at those dollars; a thief could steal your cash; or you could lose your house in a fire, and your money would also go up in smoke. (Sorry to sound like your grandma…)
On the other hand, there are some investing risks you definitely want to avoid. If you get an email out of the blue offering you the chance to make $3 million from a dead relative you never had, don’t send them money—please.
It’s All About You!
Obviously some risks are higher than others. So how do people deal with that when they invest?
Well, that depends on the individual. Just as there are some people who really do wrestle alligators, there are some people who will take a chance on risky investments. They’re willing to risk losing all their money because the payoff could be huge.
Most investors, however, don’t like taking wild gambles. They prefer a balanced approach that will give them a decent return, rather than hoping for that life-changing jackpot.
So, what is your risk tolerance?
That is the question investors need to ask themselves before they start investing.
There are a number of components to the answer. Key ones are:
- Investment horizon
- Life stage
In general, the younger you are, the more tolerance you will have for risk. The reason is simple: you have more time to make up lost ground if your investments turn south.
Conversely, older investors tend to be more conservative. They are less able to tolerate a drop in their investments because there is less time for them to ride out a bad market wait for it to bounce back.
Your investment horizon
This is closely related to age—but subtly different.
In general, the younger you are, the longer you can wait before cashing out your investments.
But there are exceptions. Maybe you want to own a home before turning 30. Maybe your dorm-room start-up will need cash in the next three years. In those cases, you can be young and have a short-term investment horizon.
Similarly, you can be a very healthy 65-year-old who expects to live to 100. (It’s happening more and more these days.) In that case, you’ll have a fairly long investment horizon.
Your life stage
Getting married, buying a home, having children—these are different stages of life. And your financial needs will vary depending on the stage of life you’re at.
If you’re planning to buy your first home, you’ll likely need to save a chunk of money for a downpayment. On the other hand, if you’re retiring, you probably will need a steady stream of income for your living expenses. In each case, your tolerance for risk will be different.
About Your Future
So, we’ve dealt with where you are in life. How about where you want to get to?
The question “Where do you see yourself in 5 to 10 years?” is usually reserved for job interviews, but it is also a key factor of your risk profile. And it comes down to two things:
- Future earning capacity
If you have modest goals—eating safely, crossing the street, surviving your morning bath—you won’t really need a lot of money from your investments.
On the other hand, if you want to fly your own plane to Aruba for breakfast, then jet off to Hong Kong for an evening at the casino next to Mr. Bond—James Bond—well, you’ll need a fair bit of cash. In that case, you’ll need to take on a lot more risk to reach your goals.
Your future earning capacity
Let’s take two people: a future doctor and a future poet. It’s a pretty safe bet that the future doctor will earn more than the future poet—probably by a factor of several hundred.
And that means he can have a more aggressive risk profile than the poet. He can afford to speculate and make risky investments. If his bets don’t pay off, he doesn’t have to worry. He’ll still have years of healthy earnings ahead that will ensure he won’t starve.
The poet, on the other hand, is already likely to starve. (After all, he’s a poet.) If he has money from an inheritance to invest, he wants to make sure it pays off: he won’t be able to fall back on his future earnings. So he’ll want to avoid really risky investments.
Levels of Risk
Poets, doctors, alligator wrestlers—there are about as many different risk profiles as there are individuals. For investment purposes, though, we can divide risk tolerance into three levels: low, medium and high.
Low Risk Tolerance (Conservative)
If your tolerance for risk is low, you will follow a conservative investment style. This means choosing investments that will give you lower returns, but that will also preserve your capital. These investors are considered risk averse.
But this approach is not without its risks. Remember that investment returns are calculated after inflation and taxes. If you are too conservative, you could end up losing money. So even for a conservative investor, a little risk can be a good thing.
Medium Risk Tolerance (Moderate)
If you have medium risk tolerance, you will follow a moderate investment style, looking for average or better-than average returns on your investments. In exchange, you’ll be willing to accept some losses to your portfolio in the short term. That’s what sets you apart from the conservative investor.
On the other hand, you don’t want to see really big swings in the value of your investments. You’re not a big gambler.
High Risk Tolerance (Aggressive)
If you have a high tolerance (or appetite) for risk, you’re looking for big returns. You’ll follow an aggressive investment style. You realize, however, that you could lose a lot of money, too. In all likelihood, you believe that over the long term your strategy will pay off, even if you suffer a lot in the short term. Unlike conservative and moderate investors, big swings in the value of your investments don’t cause you to lose any sleep.
So, what is your risk tolerance?
Investing is a long-term prospect. Finding your comfort zone requires experience and education. And—as was pointed out earlier—your risk profile changes over time.
There are lots of resources online to help you. Take this free quiz that evaluates your risk tolerance. And keep up with these courses. The more you know, the better you’ll be able to assess your risks.
In the meantime, chew your food carefully, floss at least once a day, and don’t windsurf near Niagara Falls…