Determining Your Risk Tolerance

One of the very first things that just about any person, magazine, book or blog about money and investing will tell you to do when you are getting started in the investing game is to determine your risk tolerance.  It's one of the most common pieces of advice you will encounter while you read up on investing, along with diversifying your investments and dollar cost averaging (that is, making regular investments of the same amount, regardless of what the market is doing).

But, just what is this whole risk tolerance thing?  Why does it get such prominent mention in so many sources of financial advice?  How can you determine your own risk tolerance?  More to the point, what should you do about once you know your level of risk tolerance?  In this article, I hope to shed some light on how you can answer all these questions.

Risk Tolerance 101

So, what is risk tolerance?  The general concept, as so clearly illuminated by Investopedia, is that it's the degree of tolerance an investor has for suffering losses in their portfolio.  With any investment, there's some degree of risk; risk that the investment could decline in value, risk that dividends could be decreased (or cut entirely), risk that the company or organization backing the investment might go bankrupt and the investment will become worthless.  It's impossible to find a completely risk-free investment; even Treasuries, often considered the low-risk standard by which risk levels are judged, have some risk.  (Particularly if the US government doesn't get this whole debt ceiling increase mess taken care of before the end of the month…)

Before I get anyone too upset talking about the deficit, here's a puppy.

Your risk tolerance, then, is basically a measure of how much threat of loss (risk) you can handle (tolerate) in your portfolio.  If your portfolio could drop by 50% tomorrow without adversely affecting you (at least, immediately), you have a very high risk tolerance; on the other hand, if a more modest 10% decline has the potential to seriously derail your plans, you have a low risk tolerance.  This risk tolerance will change as you go through life, particularly as you get close to retiring; when you are thirty years away from retirement or so, you can tolerate the possibility of a decline in your investments much better than when you are three years away.

What Determines Your Risk Tolerance?

There are quite a few factors that determine how much risk you are able to tolerate in your investments.  Here are three of the most important to help give you an idea of what you should consider:

1. Length of Time Until Retirement (Or Your Other Financial Goals): Probably the biggest determinant of your risk tolerance is how much time you have available to meet your desired goal.  As mentioned above, you'll have a much greater risk tolerance with three decades until it comes time to start drawing down your investments, rather than three years.  While retirement is obviously the biggest goal most of us will save for, there are other goals where investing might be helpful (building up money for a home, providing money for a child's college education, etc.), and so it's possible you might have different risk tolerances for different goals.

2. How Much of an Increase You Need to See In Your Money: Depending on your particular goal and the amount of time you have to reach that goal, you might need to take on a higher level of risk (or you may be able to decrease your level of risk).  If you are able to save only a fraction of the amount of money you will need in retirement, for example, you'll need to use investments that have higher growth potentials than if you were able to save all the money you need (and thus, only had to worry about preserving your wealth).  If you need, say, 8% average annual growth to meet your retirement goals, you'd have to invest in something like stocks, which offers the potential for high growth coupled with the possibility of substantial losses.

3. Your Emotional Ability to Handle a Financial Loss (or the Potential for a Financial Loss): No discussion of risk tolerance would be complete without mentioning your personal tolerance.  If you are likely to pull all of your money out of the stock market at the first sign of a dip, and get back in until the market has already shoot back up, you have a low risk tolerance.  (That said, when investing, you should try to take your emotions out of the picture as much as possible; if you get too emotionally involved, you'll end up making unwise monetary decisions and hurt yourself in the end.  Try to disengage your emotions as much as possible while investing.)

How Do I Find My Risk Tolerance, and What Do I Do With That Information?

Ah, the $64,000 question.  There are risk tolerance questionnaires offered by most investment and money management firms which can help you to get an idea of how much risk you can tolerate.  If you answer them honestly, and really try to picture yourself going through the scenarios they present, you can get a decent idea of how much risk you can tolerate.

That said, while questionnaires can be useful, they aren't perfect; it's easy enough to say that you'll ‘weather the storm' when something goes wrong or ‘double down' on investments that have a single bad year, but when it happens in real life, it's a much different situation.  A better view of your REAL risk tolerance could be gathered by looking at what you did during the last downturn; if you pulled all your money out of stocks, you probably have a very low (emotional) risk tolerance, while those who started putting as much extra into their investments as they could afford have a high risk tolerance.

What do you do with this information?  Well, first you can tweak your investments to more accurately reflect your risk tolerance. If you have a low risk tolerance, consider increasing the amount you allocate to safer investments like bonds and cash equivalents.  Don't change so much that you put your goals at risk, but if shifting 5-10% of your portfolio makes it easier for you to sleep at night, it's probably worth a slightly smaller investment return.  Similarly, if you have a high risk tolerance, consider bumping up your stock allocation; you should be able to handle the higher potential losses, and the increase could speed up when you reach your investment goal.

That said, though, don't let your personality get in the way of your financial goals. Tweaking your asset allocation is one thing; completely changing it, by going all bonds twenty years before you retire or all stocks one year before you retire, is another.  If you let your personality dictate your investments more than your current financial needs, you could end up hurting your financial plans as a result.  After a small adjustment, if that, you should leave most of your portfolio alone, although you can consider…

Setting aside a small portion of your portfolio to meet your emotional needs. If you simply can't help the urge to fiddle with your investments, use five or ten (definitely no more than twenty, and even that's a bit much) percent of your portfolio and invest it however you wish (in a separate account, of course).  If you have a high risk tolerance, you could invest it in speculative stocks or other types of speculation, with the knowledge in the back of your head that even a huge loss won't mean that you're stuck working until you're ninety-five.  If you have a low risk tolerance, you can invest it in rock solid blue-chip stocks or bonds, and use it to remind yourself that even if the market is delivering a beating to your main retirement portfolio, you still have a nice reserve.  (And that, when the market picks up and your main portfolio recovers, you aren't going to be left behind.)  Make sure that your main portfolio is invested in a way that meets your financial needs in the appropriate amount of time, and use the side portfolio as a supplement to express your emotional investment needs.  Adding a little distance between your emotions and your portfolio can be a great help in keeping them from overwhelming you and causing you to make bad decisions.

How much risk can you tolerate?  How do you keep your risk tolerance from causing you to make poor investment decisions?  How much should your risk tolerance affect your investment style?

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