Risk tolerance is a term we have all heard thrown around. But what does it really mean and how does it apply to you? And what do you need to consider when determining your answer to this seemingly easy question?
When it comes to investing, risk and reward go hand-in-hand. All investments inherently involve some degree of risk, but the level of risk varies based on the type of investment. Certificates of deposit (CDs) and Treasury bills are examples of low-risk investments; while buying securities such as stocks, bonds, or mutual funds carry a higher degree of risk. It is important that you know and understand the degree of risk involved in any investment you make.
In determining your level of risk tolerance, you need to consider your age, investment experience, net worth, and the amount of capital you are willing to put at risk, and the actual investment or trade being considered and your investment objectives.
Common sense might suggest that an older investor has a shorter amount of time in which to invest and would have a low risk tolerance versus a younger investor who has time to recoup losses and would, therefore, have a higher risk tolerance. But age is only one of the factors in determining risk tolerance. A retired individual who is able to live off the interest of his or her investments without touching the principal may have a higher risk tolerance.
Your investment experience must also be carefully considered when determining your risk tolerance. How long have you been investing? How familiar are you with the various types of investments available and the degree of risk assigned to each of them? You need to fully understand the investment vehicle and the risk involved before investing any of your hard earned money. If you are a novice to investing, maintain a low risk tolerance. As you learn more about investing and the inherent risks of each investment vehicle, you can increase your risk tolerance.
Your net worth and the amount of capital you are willing to risk should also be important considerations when determining risk tolerance. Your net worth is simply your assets minus your liabilities; your risk capital is the amount of money you have available to invest that, if lost, will not affect your lifestyle. Good judgement would dictate that someone with a higher net worth would have more risk capital. But remember the saying, “The higher the climb, the harder fall.” Someone with a high net worth and a high amount of risk capital has much more to recover from an entire loss than someone who had very little to invest to begin with.
Ask yourself: “What is my goal or objective in making this investment?” Are you saving for your child’s college fund? Or are you using true risk capital in an attempt to earn extra income? Understanding the objective of your investment will help you determine your risk tolerance. If the funds you are investing are earmarked to cover a specific expense and the amount of risk capital you have is small, you will want to focus on investments that are low-risk. Conversely, if you have a high amount of risk capital and experience trading futures – investment vehicles that carry a high amount of risk, but also carry the possibility of a large return – your risk tolerance may be higher.
Knowing your risk tolerance goes beyond being able to sleep at night, secure in the belief that you have made the right investments for your particular set of goals and objectives. It is a complex process of analyzing yourself, your knowledge, and your financial situation, and balancing it against your goals and objectives. The financial professionals at Tax Saving Professionals will help you determine your risk tolerance and show you how your unique circumstances can ignite your hidden money.