A good investment advisor will help his or her client determine their personal tolerance for risk and then allocate their investments accordingly. What is “risk tolerance?” It’s the measure of volatility and uncertainty an investor can handle when faced with a negative change in the value of his or her portfolio (no one complains about positive changes).
Each investor’s personal risk tolerance is different and as such, the way they allocate their assets will differ. A good investment advisor will ask a lot of questions to determine your tolerance for the daily, weekly, monthly, or annual volatility you can stomach.
Risk tolerance varies by age, income needs, financial goals, . A 75 year old retired widow usually has a lower risk tolerance than a single 30 year old junior executive, mainly because the 30 year old has a longer time frame to make up for any portfolio losses incurred due to volatility and risk.
How to Assess Your Risk Tolerance
To determine the asset allocation that suits you best, you first need to assess your risk tolerance — the amount of risk that you personally feel comfortable taking on with your investment portfolio. It is generally accepted that there are three groupings of risk tolerance:
- High risk tolerance? Also called aggressive investors, these types of investors can tolerate the short-term volatility of riskier investments because of the superior long-term returns that those investments typically provide.
- Medium risk tolerance? These are known as moderate investors. Their portfolios usually have an even mix of investments that will likely grow in value, such as stocks, and investments that provide steady income with lower risk, such as bonds.
- Low risk tolerance? Also known as conservative investors, these investors usually put their money in lower risk investments, such as bonds, that provide a steady stream of income without the prospect of high returns over time, or in cash.
Even within each of these groupings, investors can have wide variations. These are just rules of thumb, not set in stone. Certain aspects of your investing may have different risk tolerances: Money you invest for retirement, money you invest for junior’s college education, and money you invest to build your home in a few years will all have different risk tolerances.
To determine your ideal risk tolerance (regardless of why you’re investing), consider when you’ll need the money from your investments, your financial situation, and your personal response to risk.
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When will you need the money?
When you’ll need the proceeds from your investments has a large impact on your personal risk tolerance. Sometimes investment advisors refer to this as your “time horizon.” Your time horizon is the amount of time you have before you’ll need the money you invest. For example, a 30 year old who doesn’t plan to sell his or her investments until age 65 has a 35 year time horizon.
Remember that your time horizon isn’t just a function of your age or when you expect to retire. As mentioned above, a young investor hoping to grow his or her investment portfolio for the purpose of buying a home in three years has a short time horizon but that same investor putting money aside for retirement will have a long time horizon for those specific investments.
How Time Horizon Impacts Risk Tolerance
Time horizon has a direct relationship to risk tolerance:
- The longer your time horizon, the greater your risk tolerance
- The shorter your time horizon, the lower your risk tolerance
Your Personal Financial Situation
Another major factor in your risk tolerance is whether you will depend on the income that your investments provide. A retiree who has no other source of income other than what’s generated by his or her investments is dependent on investment income. A person who has a secure job that pays the bills and provides extra money for savings is not dependent on investment income.
Investors who depend on investment income have a low risk tolerance, since they can’t afford any interruption to that income. Investors not dependent on investment income have a higher risk tolerance, since they can accept the short term volatility in exchange for higher long-term returns.
Your Personal Response to Risk
In addition to the risk that you can accept financially, risk tolerance also includes how you feel, personally, about taking risks and losing money. Always consider adjusting your risk tolerance based on your personal response to risk when determining your ideal asset allocation.
- If you avoid risk in everyday life or if you’re a worrier: It’s likely best for you to avoid high-risk investments, such as small-cap stocks or leveraged ETFs. In exchange for potentially lower returns, you’ll have less stress and lower volatility.
- If you enjoy risk and don’t worry easily: You’d probably feel comfortable buying risky investments—assuming that your time horizon and life situation support that high-risk approach.
Risk is unavoidable
No matter how you slice it, risk is unavoidable. Even the highly conservative investors who invest solely in cash risk NOT getting the returns they need to fulfill their investment requirements.
Make sure you determine your personal tolerance for investment risk in your portfolio and if you’re working with a personal financial advisor, insure that he or she knows and understands your investment goals and objectives in light of your risk tolerance.
Tomorrow, I’ll show some sample portfolios for each of the three styles of investment risk tolerance so you can make your own investment decisions.