How do you feel when you hear the word “risk” used about your finances?
Do you see a chance for excellent returns?
Are you able to picture the “adrenaline rush” of investing?
Do you ever worry that you won’t have anything left?
Do you consider the risk only a necessary step in the investment process?
An investor’s risk tolerance is the amount of risk they are prepared to take. But it might be challenging to determine your level of risk appetite. The risk may also offer opportunity, thrill, or the chance to make significant gains—a “you need to be in it to win it” mentality.
But how can a private investor assess their level of risk tolerance? What benefits may investors derive from grasping this idea regarding portfolio diversification?
Risk tolerance: What is it?
The amount of risk an investor is willing to take is called their risk tolerance. Nevertheless, figuring out your degree of risk tolerance may be difficult. A “you have to be in it to win it” approach may be associated with the risk and the opportunity, thrill, or potential for substantial rewards.
But taking a risk means that you are willing to lose money, that you can handle market changes, and that you can’t predict the future.
In reality, behavioral experts assert that “loss aversion,” or that fear of losing something may influence decisions more than the expectation of profits, might affect how you see risk. As risk tolerance is based on how comfortable you are with uncertainty, and you might only know how willing you are to take risks once you face a possible loss.
Is it risk tolerance or risk capacity?
While sharing a name, your risk capacity and risk tolerance often operate independently.
Your unique financial condition determines your risk capacity, or the number of potential losses you can accept.
Contrary to risk tolerance, which may not alter throughout your life, risk capacity is more malleable and adapts to your financial and personal goals and the timeframe for reaching them.
Given your income requirements, you might be less likely to conveniently ride out a bear market if you have a mortgage, your own business, children close to graduating from college, or aging parents who depend on you financially. But, again, this contrasts with someone who is single and has no significant financial commitments.
A financial shock such as a job loss, an accident with high medical costs, or even a windfall may also impact your investing choices by changing the level of risk you can bear.
What are your financial goals?
Your investing goals must also be considered when determining how much risk may be accepted. For example, how much risk do you wish to take with the money you invest for your retirement or your children’s college tuition?
On the other hand, if you are utilizing natural risk capital or available cash to try to make more money, greater risk could be accepted.
Interestingly, some people are fine with trading higher-risk securities with their retirement assets. Make sure you understand what you are doing if you only use this to protect your transactions from tax exposure, such as when you trade futures in an IRA.
If you are an experienced futures trader, only use a small amount of your IRA money, and don’t depend on one deal to decide whether you can retire, this could be a good plan.
You might reconsider engaging in this much risk, though, if you are using your whole IRA to trade futures, have little to no net wealth, and are only seeking to minimize tax exposure for that deal you consider a “sure thing.”
Futures already enjoy a more favorable capital gains treatment than other types of income; the lesser of the two capital gains rates will be applied to 60% of your earnings in the future.
Given this, why would someone with a low net worth need to put their retirement funds at such risk? In other words, you should only sometimes do something simply because you can.
What is your investment experience?
Your degree of investment experience must also be considered when figuring out your risk tolerance. Are you a novice trader or investor? Do you already have some experience in this field but want to expand into something else, like selling options? Trading and investing are no different from other new endeavors because it is wise to start cautiously.
Before making a significant financial commitment, gain some experience. Always aim for the “protection of capital” and keep in mind the classic saying. Only if the worst-case outcome will allow you to survive to fight one more day does it make sense to take on the right amount of risk for your circumstances.
How do you make your risk tolerance into a financial plan?
Plenty of online questionnaires can give you a starting point for risk tolerance and how to turn that into an investment strategy. Since you want your suggested portfolio’s asset allocation mix to represent your risk tolerance most closely, being honest is undoubtedly the best action in this situation.
The next stage is to familiarize yourself with the standard performance information for your portfolio once you have determined where you lie on the risk spectrum. Again, the less likely you will respond emotionally when things are complex, the more you will know about what to anticipate.
Savvy investors take both risk and reward into account. Stocks and other investments with higher projected returns (and more volatility) tend to be riskier than more conservative portfolios made primarily of bonds and cash, which have lower volatility.
However, owing to constantly shifting market circumstances, even the most cautious portfolio might suffer short-term losses. This is why having a diverse portfolio with a wide range of investment possibilities is crucial.
Consider investing $10,000 in one of the three fictitious asset-allocation strategies shown below at the start of 1970. And through the end of 2016, you recalibrated your portfolio annually to ensure the appropriate mix of stocks, bonds, and cash was still present.
As a result, the riskiest portfolio would have increased to $892,028, the most intermediate portfolio to $676,126, and the most conservative investment to $389,519.
What is your risk tolerance? It seems like a simple question, but numerous factors must be considered. For example, your experience, age, net value, risk capital, and the specific investment or transaction being evaluated will all affect the response.
After giving this some thought, you can use this information to develop a well-rounded and diversified trading and investment program.
Image credit: [Wutzkoh]