All forms of investing come with some degree of risk.
No matter how “safe” or reliable an investment strategy may seem, there’s always a chance that you’re going to suffer losses – and possibly total losses. This isn’t necessarily a bad thing; in fact, in some ways, it’s a necessary ingredient in any economic environment.
There are also very different types of investment risk.
That said, if you want to be a successful investor, it’s important to understand your personal risk profile, including the amount of risk you can reasonably tolerate. Risk isn’t something to fear, but it’s something you do need to acknowledge and calculate if you want to succeed.
First, let’s cover the basics. What is risk tolerance anyway?
In every investment is at least some risk. If you buy a house, there’s a chance that property values in the neighborhood could plummet, that the real estate market would crash, or that you won’t be able to find a tenant to supplement your income enough to cover the mortgage. If you buy a stock, there’s a chance it will idle there’s a chance you could lose money, and there’s a chance that the company could fail entirely.
Risks vary depending on the assets you’re looking at, current market conditions, the nature of your purchase, and dozens of other variables. You’d be forgiven for thinking that riskier investments are inherently worse, but this isn’t necessarily the case. For example, would you prefer a 50 percent chance of earning $1,000 with a 50 percent chance of losing $50, or a 10 percent chance of earning $1,000,000 and a 90 percent chance of losing $90? The latter scenario is, in some ways, riskier, but the potential payoff is much higher.
That’s why it’s important to understand your personal risk tolerance. Your risk tolerance is a measure of how much risk you’re willing to incur in your own investment portfolio. The higher your risk tolerance is, the more risks you’re willing to take.
Some economists like to differentiate between risk tolerance and risk capacity, but this is merely a semantic distinction. In most contexts, risk tolerance refers to the amount of risk you’re emotionally able to take, in line with your personal preferences and your long-term outlook. By contrast, risk capacity is the amount of money you’re able to lose without being financially devastated.
As an example, if you have a net worth of $10 million, it might be completely within your risk capacity to lose $100,000, but your risk tolerance might forbid you from such a potential loss.
How much risk are you willing to take? That’s a hard question to answer, considering risk is such a subjective and abstract thing.
But most investors categorize their portfolios as being conservative, moderate, or aggressive. Conservative portfolios tend to focus on assets that are extremely reliable, with low rates of failure and minimal potential losses. Aggressive portfolios tend to be highly risk tolerant, capitalizing on assets with high potential pay offs, even at the expense of higher risk. Moderate portfolios, of course rest somewhere in the middle.
Conservative assets include things like bonds, stable ETFs, and even some financial products like CDs. Aggressive assets include things like volatile stocks, certain commodities, and risky real estate investments. Moderate assets include things like mid-cap stocks, niche ETFs, and REITs.
The question remains: how are you supposed to assess your own personal risk profile?
These are some of the most important variables to consider:
When assessing your personal risk profile, it’s important to take inventory of all your current assets. What does your investment portfolio look like? What percentage of your assets are currently being held in aggressive assets, moderate assets, and conservative assets? Some financial apps and wealth management platforms will compute this breakdown on your behalf and display it for you, making this analysis simple and straightforward.
From there, it’s on you to revisit your current age, investment time horizon, income sources, and personal preferences. Does your portfolio currently reflect your risk tolerance and risk capacity? If not, what changes need to be made? If you’re like most investors, gradual moves – like shifting some money from aggressive assets to more conservative ones – is all it takes to keep your portfolio balanced and you risks in line.
Making investment decisions as an individual is always challenging, but it’s even more difficult if you’re inexperienced or if you don’t have access to advice or wisdom from more seasoned investors. If you’re trying to reassess your position as an investor, or if you need help making a major investment decision in the future, you’re in good company – contact us for a free consultation today!
*Keep in mind that a personal risk profile should still be aligned with the help of your financial planner. This is not investment advice.