There’s no one right or wrong way to approach risk as an investor, but it is important to intentionally decide how much risk you plan to take on.
A big part of that decision should depend on your level of risk tolerance, which is the degree of risk you’re comfortable having in your portfolio. Understanding your risk tolerance and investing accordingly will help you not only reach your goals more efficiently, but also maintain your peace of mind in the process.
Why is Risk Tolerance Important?
How do you tend to think about financial risk? Are you excited by the idea of high risk, high reward opportunities? Or does the thought of potentially losing money make you anxious?
At its core, risk tolerance is really about your ability to handle uncertainty. If you’re someone who thrives on the idea of possibility and is comfortable with the unknown, you may want to invest more aggressively than someone who is stressed out by the idea of unknown outcomes.
Wherever you fall on the risk tolerance spectrum, the most important thing to remember is that it’s OK to prioritize your own peace of mind. While it’s often good to push yourself outside of your comfort zone, it’s not healthy to invest in riskier ventures if that means you won’t be able to sleep at night.
Risk Tolerance vs. Risk Capacity
Risk tolerance does not exist in a vacuum, and while most people’s tolerance levels stay the same throughout their lives, your risk capacity will change from year to year, and even moment to moment. Even if you’re someone who’s willing to take on investment risk, doing so may not always be the wisest decision.
For example, if you have a child who’s going to college next year, now is probably not the best time to invest in volatile stocks or real estate. But if you’re an empty nester who doesn’t plan to retire for quite some time, you might be in a better position to invest in assets that have some level of uncertainty.
Similarly, if you have a large amount of money tied up in an illiquid investment for a certain number of years, you may want to avoid risk in other parts of your portfolio for that period of time.
5 Questions to Help Determine Your Risk Tolerance
It’s easy to say you’re comfortable with risk when the economy is doing well, but the true test of risk tolerance is how you handle downturns or periods of uncertainty.
To help determine your risk tolerance, ask yourself the following questions:
- What is your reason for investing? (Also, understand WHY you’re taking action).
- Is it more important to you to build as much wealth as possible, or to protect the wealth you already have?
- If given the choice, would you invest in (a) an asset that has a high annual return but is likely to lose money for at least one year, or (b) an asset that has a lower return but has never had a net annual loss?
- How often do you have trouble sleeping at night because you’re worried about your investments?
- Do you feel tempted to pull your investments at the first sign of a downturn, or are you comfortable holding out for long-term appreciation?
How to Invest According to Your Risk Tolerance
Once you understand your risk tolerance and your current risk capacity, it’s much easier to make informed investment decisions that don’t cause you unwanted stress or instability. There is, however, one more important factor to consider: your specific investment goals.
Aside from personality, one of the factors that plays the biggest role in a person’s risk tolerance is often their time horizon. If, for example, you’re in your forties and your goal is to build retirement savings, then you’re much more likely to feel comfortable investing in assets (like real estate) that may be volatile in the short-term, but are likely to appreciate in value over time.
On the other hand, if you’re about to retire within five years, you may be more conservative about your investments, focusing on stable assets that will help you slightly increase your wealth without putting your existing savings at risk.
With all of these factors in mind, you can more confidently select both the type of assets you invest in and the amount you invest.
Find an Investment Partner Who Understands Your Goals
At the end of the day, you know your goals and your comfort levels better than anyone else. That’s why it’s so important to make sure anyone you work with on investments is willing to listen to your needs and build a plan that works for you.
To learn more about how FGCP can help you find tax-efficient, direct investments that align with your unique goals and risk tolerance, fill out this form to get in touch.