Investment Risk and How To Determine Risk Tolerance

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This is a guest post by Jason Topp. Jason is the author of the personal finance blog Redeeming Riches, where he writes about money & finances from a biblical perspective. You can follow Jason on Twitter and/or subscribe to his blog to receive his article updates.

The Five Investment Risk Categories

Moderately Conservative
Moderately Aggressive

What is right for you?

Risk tolerance is a difficult thing to define.  Let’s face it, people seem to love risk when markets are good and hate risk when there is a downturn.  Most people I know would love to find an investment that makes a lot of money without taking on much risk.  Living by Socrates’ guiding rule of “know thyself” couldn’t ring more true when determining your risk tolerance for your investments.

Unfortunately, too few people truly know themselves, their comfort levels or their goals when it comes to investing, which leads to many problems – most notably “selling low and buying high”.  Here are five questions you can ask to get a more accurate picture of what kind of risk you should be taking with your investments.

5 Questions to Ask to Determine Your Risk Tolerance

What is Your Age?

Typically speaking, the younger you are the more risk you can take.  If something goes wrong, you have more time to make up any losses.  If you are in your early thirties, you might have another 30 years to go before you reach retirement, which means you’ve got time on your side and can probably ratchet up your risk for a while.  However, if you are in your mid fifties and are looking to retire in the next five or 10 years, then we probably want to scale back a bit and shore up what we have.

How Comfortable Are You With Risk?

Do you drive with a lead foot, roll the dice at the casinos and like to sky dive?  You are probably OK with taking on a little risk in your portfolio.  Are you a conservative person who fears the unknown and likes to keep a consistent schedule?  You may want to risk very little.  Knowing your comfort level is a key to managing risk and expectations for your investments.  The above are extreme examples, but looking at who you are as a person, your temperament and lifestyle will help give you a guideline of how much risk you should be taking on.

What is the Purpose of the Money?

Knowing the goals you have for your money is another key component to determining risk tolerance.  If you are saving for a downpayment on a house you plan to buy within the next two to three years you certainly do not want have an aggressive risk tolerance because you will need the money soon.  In the same regard, if you are building your nest egg for your retirement which is 20 years away, you can probably increase your risk a bit.  Knowing the purpose behind the money will help you determine your time frame, which helps determine the appropriate amount of risk you should be taking.

What Do You Do When Things Go Wrong?

Inevitably markets will go down, it’s the nature of the beast.  The question is what do you do when things don’t go the way you had hoped?  Are you the type of person that adapts easily, takes things in stride and rolls with the punches?  If so, you might be able to take on a little more risk.  If you are the type of person who frets about your statements, worries about the day-to-day decline in your investments and is anxious about what might happen if the market does not recover, then you probably need to ease up a bit on your risk.

Do You Make Emotional Decisions?

Sticking to a course of action is a best practice when it comes to investing.  This is not to say that you never change your plan or your risk tolerance, but if you are prone to making emotional decisions dependent on how you feel rather than sticking to something to accomplish a goal, then you may want to scale back your risk as well.  Investing is an emotional proposition.  When it comes to investing, emotional decisions can hamper your growth and leave you with a lower return.  You would probably make a better return by reducing risk a degree or two over the long run rather than shifting your portfolio around every time you think the market is going up or down.

These questions are designed to give you a general idea of how much risk you should be taking in your investments.  There are many great tools and resources on personal finance blogs and around the web to help you determine what your model portfolio should look like.  MSN Money has a nice 20-question risk assessment to help you determine your risk tolerance as well.

Investing can be a fun and profitable experience when handled correctly and aligned with who you are as a person.  Knowing yourself, understanding your goals and sticking to a plan will help you navigate through difficult markets and keep you from making poor investment decisions.

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1 Craig @ Money Help For Christians

I think the current economy provides the perfect environment for determining your true risk tolerance. Many people think about their risk tolerance when the market is high and their assumptions are often optimistic about what they can actually endure. Consider your feelings right now and you will be on the right track to knowing your true risk tolerance. Thanks for the post.

2 Jason @ Redeeming Riches

@Craig – That’s so true. When the market was at its peak in late ’07 seemingly everyone wanted to be more aggressive with their investments and then the crash came and it was amazing how many people were jumping 2 or 3 steps down on the risk profile! That’s why it’s so important to really know who you are as an investor.

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