Step 6 - Determine Your Risk Tolerance
You know that deciding to invest some of your money in the market automatically means you’re setting yourself up for possible loss.
But how much losing can you take? Does the thought of your stocks plunging make you sick to your stomach? Or are you a genuine thrill-seeker who loves the rush of adrenaline you get when you think about putting your money somewhere shaky?
Determining your risk tolerance is an important step to take for ensuring you’re completely comfortable with your investments. You might also come across trade recommendations that are discussing options based on different risk tolerances.
While your risk tolerance will change according to your age, income requirements and financial goals, there is no fixed label for those who fit certain criteria. There are simply too many variables. For example, most people think that the younger you are, the more of a risk-taker you’ll be. They reason that the years ahead afford you the freedom to take more chances with your money. While this may be true in general, it is not a fixed rule, and determining your risk tolerance depends on several variables besides age.
So, how do you determine your risk tolerance? Consider the following before answering the question:
1.) Time frame
The first factor to determine is the actual length of the investment horizon. When will the funds be needed? Even a younger investor can have a short-term horizon if they’re trying to earn enough capital for a goal they hope to fulfill in the near future, such as buying a house. If the investment horizon is indeed short, the risk tolerance should shift toward being more conservative, regardless of the investor’s age. For long-term investments, there’s room for more aggressive investing.
If you’re an older investor, don’t fall into the trap of thinking that, just because you’re pushing 70, you need to move everything into conservative investments. This may be suitable advice for some, but it’s not recommended as a one-size-fits-all approach. For example, a retiree who has sufficient funds to live off the interest without touching the principal can safely invest in volatile stocks. Also, with today’s growing life expectancy, a 70-year-old investor may still have a 20-year investment horizon – or more! When determining your risk tolerance, be sure to consider your actual time horizon, irrespective of age.
2.) Risk capital
An obvious factor of your risk tolerance is going to be how much money you have available to put into the market. What is your net worth? To find this number, simply add all your assets and subtract your liabilities. Risk capital is defined as the amount of money you have available to invest or trade that will not affect your lifestyle if it is fully lost. It is also referred to as liquid capital, meaning assets that can easily be converted to cash.
Naturally, an investor with a higher net worth will be able to take more risk. The smaller the percentage of your overall net worth the investment represents, the more aggressive the risk tolerance can be.
Unfortunately, those with little or even no net worth are often attracted to riskier investments because of the lure of quick and large profits. Bear in mind, though, that when too much risk is taken with too little capital, a trader can be forced out of a position too early to make the investment worth it.
On the other hand, if an undercapitalized trader using limited risk instruments “goes bust,” it shouldn’t take that trader long to recoup the losses. Contrast this with a high-net-worth trader who throws caution to the wind and puts everything into one risky stock and loses – it will take this trader a lot longer to recover.
3.) Investment objectives
Your investment objectives are another important factor in determining your risk tolerance.
Are you saving toward a specific goal? Are you investing your child’s college fund with the hopes that it will grow? Are you trying to earn enough to support your retirement? If your goal is to raise enough capital for a pressing need, you will likely be more risk-averse. Or, you may be so desperate to raise those funds that you’ll make some hasty decisions.
On the other hand, if you’re simply trying to increase your net worth with extra capital, you’ll probably be more open to investing in riskier stocks.
Knowing your risk tolerance goes beyond being able to sleep at night without stressing over your investments. Ultimately, knowing your risk tolerance – and sticking to investments that fit within it – should keep you from complete financial ruin and allow you to invest with a clear head.