Determining Your Risk Tolerance
All investments fluctuate over time, whether you invest in stocks, bonds, commodities, mutual funds, or ETFs. Usually, the changes are small from day to day. But sometimes, these fluctuations are quite significant, especially when we look at them for a certain month or year.
Your risk tolerance is your attitude toward investment risk and how much volatility you are willing to accept in your portfolio.
- If you have a high-risk tolerance, you may be able to invest in more volatile assets like stocks whose average returns are likely to be higher over a long time horizon.
- Conservative investors have a lower risk tolerance and should tilt their portfolios more toward stable investments like short-term bonds.
Don’t think of this as an “all or nothing” approach.
Your risk tolerance is measured on a gradual scale, and you can build a portfolio to match whatever yours may be. It’s very important that you align your investments with your risk tolerance. If you invest too aggressively, and push yourself outside of your comfort zone, you risk abandoning your strategy when the market gets rough—which could do more harm than good!
So how do you determine your risk tolerance? It’s hard to know EXACTLY where you stand until you’ve been through a few market cycles and can see how you really feel, but there are some helpful tools we can use to get a very good idea.
Our team prioritizes having detailed conversations with clients to identify their unique risk tolerance, and to reverse engineer a strategy that makes the most sense for them.
When doing this, there are a few areas you need to look at –
- How much risk you need to take to accomplish your goals.
- How much risk you may want to avoid depending on how quickly you need the funds you’re investing.
- How much risk you’re comfortable taking on in your portfolio – regardless of what you “need”.
For example, you may have a long time horizon before you need to tap into your retirement savings. Traditional planning models may automatically set you up with a medium to high risk allocation to maximize your earning potential given the fact that you have more time to recover from dips in the market.
However, if you are also risk averse, this may sound like a nightmare scenario. You may be better served by a portfolio that’s divided into buckets where there are differing risk levels associated with your investments. Alternatively, you may find that saving more while taking on less risk is the path you feel most comfortable with and meets your needs best.
Remember, when it comes to risk tolerance, there isn’t right or wrong. There’s just YOUR risk tolerance, and knowing what that is helps you and your financial planning team make the best decisions about your investment plan.
Your risk tolerance also isn’t set in stone. Your circumstances, knowledge, and experience all change over time, and your risk tolerance may also change to reflect that. It’s not at all uncommon for people to be more aggressive when they are younger and accumulating savings, but gradually become more conservative as they get closer to retirement and need to be concerned with protecting their retirement nest egg.
You should re-evaluate your risk tolerance occasionally—both through discussions with your financial planner and by revisiting questionnaires – to be sure that your recorded risk tolerance is accurate.