In the investment world, there are two aspects of risk tolerance: (1) an investor’s capacity for risk, or ability to absorb losses, and (2) how comfortable an investor is with risk.
An investor’s capacity for risk is looked at purely from a financial point of view. How much money can the investor afford to lose? An investor who depends on his or her investments to pay daily expenses, and for whom a loss would represent a serious problem, has less risk tolerance than someone for whom an investment loss might merely be an inconvenience or disappointment.
How comfortable an investor is with risk, from an emotional standpoint, depends on many factors, including his or her objectives & goals, life stage, personality, knowledge of investing, and investment experience. Some investors will hang on to an investment during downturns in the market, while others will bail out at the first sign of trouble. You should only invest as much as you are comfortable with. If you find yourself losing sleep worrying about your investments, you may have invested too much or too aggressively.
Investors typically fall into three categories of risk tolerance: aggressive (those who are risk tolerant), conservative (those who are risk averse), or moderate (those who are somewhere in between). How risk tolerant you are is important, because it is one of the basic factors in determining the best investment strategy for you. Your risk tolerance can affect both the types of investments you make and the way you choose to diversify your portfolio.
What is investment risk?
In the investment world, risk means uncertainty, and refers to the possibility that you will lose your investment or that an investment will yield less than its anticipated return. That uncertainty about the outcome of an investment means that investment risk also refers to the way the price of an investment fluctuates or changes in value from time to time–its price volatility. The more the fluctuation–in frequency and in amount–the higher the volatility. Generally, the higher the volatility, the greater the uncertainty about the outcome of your investment, and the greater the potential risk involved.
There are three factors that are key to understanding risk: (1) the risk-return tradeoff, (2) the investment planning time horizon, and (3) the different types of risks that exist. You should have a solid understanding of each of these issues to select investments that maximize potential returns within your acceptable risk levels. Here is a brief discussion of each.
As risk increases, the potential for return increases. This is known as the risk-return tradeoff. Historically, investments with greater risk have tended to provide higher returns, though past results are no guarantee of future returns. The more aggressive you are as an investor, the more risk you take, and the greater chance you may have to earn a potentially higher return (assuming any return is earned at all).
Conversely, the more conservative you are as an investor, the less
risk you take, and the less potential you have to earn a high return (though you’re also less likely to lose your investment).
The length of time you plan to stay invested is referred to as your investment planning time horizon. Generally speaking, the longer your time horizon, the more you may be able to afford to invest more aggressively, in higher-risk investments. This is because the longer you can remain invested, the more time you’ll have to ride out fluctuations in the hope of getting a greater reward in the future.
Finally, many types of risk can affect an investment. Each investment is subject to all of the general risks associated with that type of investment. Risk also arises from factors and circumstances specific to a particular company, industry, or class of investments.
Note: All investing involves risk, including the potential loss of principal, and there is no assurance that any investment strategy will be successful.
An investor’s risk tolerance may not be static (although authorities argue about this). Personal and outside factors may influence your risk tolerance at any given time or over a period of time. Thus, you might expect changes in your feelings about risk when there are increases or decreases in your family obligations, major shifts in the economy, or other such circumstances. It is wise to be prepared to modify your investment plan should such changes occur.
How is risk tolerance measured?
There are tests that measure risk tolerance to assess how an investor reacts to different types of risk. These tests are designed to give you a general sense of how much investment risk you can accept, and the results are generally considered reliable. Generally, risk tolerance tests fall into two categories: investment preference & psychological.
Investment preference tests
Typically, an investment preference test is a questionnaire that addresses preferences for selected investment vehicles. It asks questions about your current financial situation, goals, and past investment experience. This type of test is easy to construct and relatively simple. The disadvantage, though, is that it does not accurately gauge risk-taking propensity because it does not deal with emotional reactions to risk.
A psychological test is a more elaborate questionnaire that attempts to gauge an investor’s attitude toward risk. This type of test generally includes questions about your feelings or behavior, or it may ask you to respond to hypothetical situations. This method of testing is easy to administer and can be fun to take. The disadvantage is that people often like to consider themselves risk-takers and may not respond as accurately as they should, only to find out during their first market downturn that they are more risk-averse than they had thought.
Download here a sample, condensed version, risk tolerance questionnaire. If you would like to re-evaluate your risk tolerance, or if you are new to investing and would like a first-time analysis, feel free to fill it out and mail it in to our office. Your financial advisor will look it over and give you a call to discuss your answers, and results, in greater detail.
Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, or legal advice. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.
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Securities and investment advice offered through Investment Planners, Inc. (Member FINRA/SIPC) and IPI Wealth Management, Inc., 226 W. Eldorado Street, Decatur, IL 62522. 217-425-6340.