While it is one of the best ways to build personal wealth, investing your hard-earned money in any market always comes with a risk. However, there are varying degrees to that risk, ranging from low to high. But having a high risk does not mean everyone should avoid it altogether. We know that significant risks can give you a greater reward, especially with aggressive financial instruments such as stocks. Does the idea of losing some of your money send shivers down your spine? Or is the possibility of winning big sound more exciting to you? Where are you in the risk spectrum?
Tolerance for risk
Risk tolerance refers to how much risk one can take. For example, in the world of investing, it is the extent to which an investor can accept the uncertainty of investment returns.
For example, you bought 50 shares of stock worth 10,000 dollars. Since it can be a volatile market, your stock may be valued less than your initial investment one month later. Although you know this scenario is possible, which you have prepared for after assessing your risk tolerance, your next move would also depend on your risk capacity. This time, it is the level of financial impact one can handle.
Are you going to cut further losses by taking out your money because you need to use it for something else? Or will you sit it out for the next few months to see if the market bounces back? The latter will be your option if you have a bigger risk capacity. Your invested money is perhaps a year’s worth of savings that otherwise would just be stashed in your piggy bank or secret repository. So even if you have a high-risk tolerance, it is deemed useless if you don’t have a high-risk capacity.
Basic categories of risk tolerance
Investors will find themselves in one of the following three categories or the middle road of two. Depending on your situation, you may also see yourself progress (or regress) from one category to another. Moreover, financial institutions would often classify their products based on these categories.
Conservative risk tolerance
A conservative investor can only take a minimal risk wherein they stay away from volatility for fear of losing money rather than gamble on the possibility of significant gains. They prefer savings-oriented products and treasury investments geared towards capital preservation rather than risk their funds in potentially high-profit but volatile options.
Moderate risk tolerance
This type of risk tolerance is present among investors looking for a healthy mix of financial instruments such as stocks and bonds. Stocks are as risky as they are more rewarding, while bonds are more stable but would have lower returns.
Aggressive risk tolerance
If your investing behavior falls under this category, you are willing to take higher risks in the name of bigger returns. As such, you would invest heavily in stocks despite their volatility. However, you are also aware that you may incur even bigger losses when the investment falls through.
Factors that affect your risk tolerance
To better understand one’s risk tolerance, several factors at play impact your investment strategy. Hence, when looking at the big picture, they can help you balance the risks and returns involved in investing.
First, ask yourself why you are investing your money, when you plan to get it, and what your expectations are profit-wise. If you intend to see your investment through your retirement, long-term financial instruments that give better yield but with higher risks will be a sensible option. When you have nearly reached your goal or timeline and find that you have made good returns, you can always re-strategize by reducing your high-risk investment and giving more importance to preserving what you have already earned.
Age and time frame
Time is an important factor when assessing one’s risk tolerance. For example, if you decide to invest in stocks, it is best to look at them as a long-term investment rather than a get-rich-quick scheme. Historically, those who have the right discipline and patience can earn an average of 10 percent annually from their stock portfolio. Meanwhile, younger investors tend to have higher risk tolerance because they have more time to recover from the dips and lows in the stock market than older clients who might need their money after only a few months or years. Hence, when the market is experiencing lows, such savvy investors don’t react by selling assets at a lower price and instead stick it out patiently until they have reached the stock value they are aiming for.
You may have been initially scared of taking on risky investments, especially if you are a rookie investor with zero knowledge. But, conversely, you have a different risk tolerance if you’ve had prior or ongoing experience in investing. Suppose you have invested in stocks albeit conservatively, for example. In that case, it might influence you to be bolder the next time around and be more willing to increase the amount of your investment because of your exposure and better understanding.
Indeed, not everyone would be willing to take risks despite an investment’s higher yield potential, and they don’t have to be. Ultimately, your goals, age, time frame, and experience will help you determine your investing risk tolerance.