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Determine Your Risk Tolerance

Determine Your Risk Tolerance

Determine Your Risk Tolerance

Santri Alat - Determine Your Risk Tolerance - Each individual has a risk tolerance that should not be ignored. Any good stock broker or financial planner knows this, and they should make the effort to help you determine what your risk tolerance is. Then, they should work with you to find investments that do not exceed your risk tolerance.

Determining one’s risk tolerance involves several different things. First, you need to know how much money you have to invest, and what your investment and financial goals are.

For instance, if you plan to retire in ten years, and you’ve not saved a single penny towards that end, you need to have a high risk tolerance  because you will need to do some aggressive – risky – investing in order to reach your financial goal. 

On the other side of the coin, if you are in your early twenties and you want to start investing for your retirement, your risk tolerance will be low. You can afford to watch your money grow slowly over time.

Realize of course, that your need for a high risk tolerance or your need for a low risk tolerance really has no bearing on how you feel about risk. Again, there is a lot in determining your tolerance.

For instance, if you invested in the stock market and you watched the movement of that stock daily and saw that it was dropping slightly, what would you do?

Would you sell out or would you let your money ride? If you have a low tolerance for risk, you would want to sell out… if you have a high tolerance, you would let your money ride and see what happens. This is not based on what your financial goals are. This tolerance is based on how you feel about your money! 

Again, a good financial planner or stock broker should help you determine the level of risk that you are comfortable with, and help you choose your investments accordingly.

Your risk tolerance should be based on what your financial goals are and how you feel about the possibility of losing your money. It’s all tied in together.

What is risk tolerance?

Simply put, risk tolerance is the level of risk an investor is willing to take. But being able to accurately gauge your appetite for risk can be tricky. Risk can mean opportunity, excitement or a shot at big gains a "you have to be in it to win it" mindset. But risk is also about tolerating the potential for losses, the ability to withstand market swings and the inability to predict what’s ahead.

In fact, behavioral scientists say "loss aversion" essentially, that the fear of loss can play a bigger role in decision-making than the anticipation of gains can color your approach to risk. Since risk tolerance is determined by your comfort level with uncertainty, you may not become aware of your appetite for risk until faced with a potential loss.

Risk tolerance vs. risk capacity

Though similar in name, your risk capacity and risk tolerance are generally independent of each other.

Your risk capacity, or how much investment risk you are able to take on, is determined by your individual financial situation. Unlike risk tolerance, which might not change over the course of your life, risk capacity is more flexible and changes depending on your personal and financial goals—and your timeline for achieving them.

If you have a mortgage, your own business, kids approaching college or elderly parents who depend on you financially, you may be less likely to comfortably ride out a bear market (given your income needs) than if you're single and not holding any major financial obligations.

A financial shock like job loss, an accident that comes with expensive medical bills or even a windfall can also affect your investment decisions by altering the amount of risk you're able to afford.

Keeping in line with your goals

When determining your risk tolerance, it's also important to understand your goals so you don't make a costly mistake. Your time horizon, or when you plan to withdraw the money you've invested, can greatly influence your approach to risk.

Your time horizon depends on what you're saving for, when you expect to begin withdrawing the money and how long you need that money to last. Goals like saving for college or retirement have longer time horizons than saving for a vacation or a down payment on a house. In general, the longer your time horizon, the more risk you can assume because you have more time to recover from a loss. As you near your goal, you may want to reduce your risk and focus more on preserving what you have—rather than risking major losses at the worst possible time.

One way to fine-tune your strategy is by dividing your investments into buckets, each with a separate goal. For example, a bucket created strictly for growth and income can be invested more aggressively than one that is set aside as an emergency fund.