Critical to your success as an investor is understanding what’s known as your personal Risk Tolerance or Risk Profile and ensuring you invest within your limits using suitable investments aligned to the risk you are comfortable taking.
What is risk tolerance?
Risk tolerance is a measure of your ability and willingness to take risks with your money, with the understanding that the performance of your investments may not align with the expected results. Many investors aim to achieve the highest possible return with their investment portfolio with suitable risk-aligned investments.
Understanding how much risk you can take with your money
When considering your ability to tolerate risk, reviewing your financial health is important. Assessing your savings, other investments, when you need to use the money, and your ability to earn income to offset investment losses and maintain your standard of living can help you better understand how much risk is suitable for you.
Understanding how much risk you are comfortable taking with your money
The other component comprising your risk tolerance is your comfort level or psychological risk tolerance. Investing can be emotional, with investors feeling stressed, scared, anxious and uncomfortable with investments carrying unsuitable levels of risk. Before putting money towards any investment, review your level of risk and contemplate how you would react to a significant loss.
Investing within your risk tolerance
Whether investing on your own or working with a financial advisor or robo-advisor, a risk tolerance assessment is an essential first step.
To better understand clients and their needs, financial advisors generally start a discovery process by having a detailed conversation with them and using a Know Your Client (KYC) form to understand their age, income, net worth, investment goals and time horizon (the desired time frame they would like to achieve their goals). The KYC form also aids the financial advisor in understanding the suitability of investment recommendations and the client’s appetite for risk by asking a series of questions about how much loss the client can handle.
When opening an investing account with a robo-advisor, investors are presented with mandatory screening questions similar to the KYC process. This gives the robo-advisor an understanding of your overall risk tolerance, financial circumstances and investment goals before assigning a suitable portfolio that meets your objectives.
Investing on your own requires you to take the time to assess your personal risk tolerance before starting. If you would like to understand your risk tolerance better, try the free Risk Tolerance Quiz from CheckFirst.
Be honest with your responses when filling out any KYC or risk tolerance form. By accurately filling out the forms, you are more likely to make suitable investments for yourself.
What to keep in mind when thinking about your risk tolerance
This is the length of time you expect to hold your investment before withdrawing funds. The longer your time horizon, the more risk you can afford to take, as you have time to recover if your investment underperforms for a period of time.
Life stages and changes
Life will change over time, and so will your risk tolerance. Starting a family, entering retirement or losing a job are all examples that can influence how much risk you feel is appropriate to take at that given point in time. With each new stage of life, consider the level of risk you are taking with your investments and adjust it to align with your new risk tolerance.
Understanding yourself and your comfort level with risk is one of your greatest tools when it comes to investing suitably for yourself. Contemplate how your emotions will play a part in your investing and what you might do if your investments experience a significant drop. Develop a portfolio that aligns with your goals but also accurately reflects your appetite for risk.