What’s the biggest fear many people have about investing? Losing money, of course. However, there’s a way to help you invest within your comfort zone and not lose sleep at night. This is known as understanding your risk tolerance.
Risk tolerance is the level of risk you are willing to assume in your investment portfolio. It reflects how comfortable you are with the potential for losing money in exchange for the chance of achieving higher returns.
How to determine your risk tolerance
- Assess your financial situation:
- Income stability: Consider how stable your income is. If you have a stable job and steady income, you might be able to take on more risk.
- Savings and emergency fund: Ensure you have an emergency fund and sufficient savings. The more financial cushion you have, the more risk you might be able to handle.
- Financial goals: Align your risk tolerance with your financial goals. Short-term goals typically require lower risk, while long-term goals can accommodate higher risk.
- Evaluate your investment knowledge:
- The more knowledgeable you are about investing, the more comfortable you might be with taking risks. Make sure you’re familiar with the five essential investing principles.
- Understand your emotional comfort:
- Consider how you react to financial losses. If you tend to worry about market downturns, you might have a lower risk tolerance.
- Age and time horizon:
- Younger investors typically have a higher risk tolerance because they have more time to recover from market downturns. Older investors nearing retirement may prefer lower-risk investments.
- Use risk tolerance questionnaires:
- Many financial advisors and investment platforms offer questionnaires to help assess your risk tolerance. These surveys ask questions about your financial situation, goals, and reactions to various market scenarios.
Here’s an example scenario that highlights how one may react depending on their risk tolerance.
Investor A (high risk tolerance):
- Age: 30
- Financial situation: Stable job, significant savings, no debt.
- Goals: Long-term growth for retirement 30 years away.
- Reaction to loss: Understands market volatility and can endure short-term losses for long-term gains.
- Investment strategy: Allocates 80% to stocks, 20% to bonds.
Investor B (Low risk tolerance):
- Age: 55
- Financial situation: Approaching retirement, moderate savings, some debt.
- Goals: Preserve capital for retirement in 10 years.
- Reaction to loss: Worries about losing money and prefers stability.
- Investment strategy: Allocates 30% to stocks, 70% to bonds.
Scenario: Imagine the stock market drops by 20% in one year:
- Investor A might stay calm and stick with their investments, understanding they have time to recover and benefit from potential future growth.
- Investor B might feel very anxious and consider moving more money into bonds or cash to avoid further losses.
By assessing their risk tolerance, both investors can choose investment strategies that match their comfort levels and financial situations, helping them stay on track with their goals without undue stress.
Once you’ve identified your risk tolerance and determined an appropriate investment strategy, you’ll be able to breathe easier when moving ahead with investment decisions. However, life changes, and so should your investment portfolio. You should consider rebalancing your portfolio periodically to realign the weightings of your assets based on your current situation to maintain your desired level of risk and return.
For example, if your goal, based on your risk tolerance, is to invest in 80% stocks and 20% bonds, you should review your portfolio periodically to ensure that this split is accurate. If it is not, you should consider adjusting your investments so that your desired target is achieved.
Market changes and life events may require adjustments to your portfolio. Fluctuations in the market can cause the values of assets to change over time. For example, during a recession, stock prices might go down while bond values remain the same. Rebalancing helps to realign your portfolio with your goals. Life events such as marriage, childbirth, retirement, or employment changes can alter your financial goals, risk tolerance and timeline. You will want to readjust your portfolio to ensure that it fits your current life stage.
For more information on the basics of investing, familiarize yourself with these essential investing principles.
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Nelson Soh, CPA, CA is a TEDx Speaker, best-selling author of Life Literacy and the 100 Day Money Mindset Journal. Nelson is also the co-founder of FSQ Consulting, a business consulting firm, and one of CPA Financial Literacy Program volunteers. You can follow Nelson on LinkedIn, Tik Tok, or Instagram to learn more about financial and life literacy.
