Have you heard that stocks are risky? It’s true that some investments are considered riskier than others.
That being said, you really should pay attention to your own risk tolerance before deciding an investment is risky. Essentially, the way you manage your portfolio depends on your risk tolerance.
Understanding your risk tolerance can also help you make positive changes to your portfolio management. Once you know where you stand, you can address weaknesses and shore up your strengths.
What is risk tolerance?
Risk tolerance represents the degree of loss you can stand within your portfolio. It reflects how you handle the roller coaster ride that is the stock market.
Ultimately, risk tolerance is all about how you can manage swings in the values of your investments.
There are two types of risk tolerance:
- Financial risk tolerance: it’s all about the numbers. Where do you stand with your finances? Does your money situation allow you to handle market swings?
- Emotional risk tolerance: it’s all about how you sleep at night. Even if you can financially handle something, your emotional response to market swings can have a negative impact on your portfolio.
Finding the perfect balance between your financial and emotional risk tolerances will help you sleep better at night while still growing your wealth through investing.
Financial risk tolerance
When considering your financial risk tolerance, take a look at a number of factors surrounding your money situation.
First, you need to figure out how much money you can afford to invest each month. This is money that you don’t mind having little access to.
For example, if you put your money into a tax-advantaged retirement account, you might not get access to it for decades. This needs to be money you can afford to have out of play while it works for you.
Next, determine where you stand financially with other issues, such as debt and other obligations. Could you still make your debt payments if something happened to your portfolio?
At the end of the day, you should be able to invest even if you have student loans and other debts. However, consider your overall financial situation carefully.
Financial risk tolerance is all about how much you can afford to set aside each month, as well as how much you can afford to lose.
For instance, you can reduce your overall financial risk by investing in index funds instead of individual stocks. This allows you to take advantage of a performance of a large swath of the market over time, rather than worry about picking the “right” stocks.
Also, as you get closer to needing money for retirement, or for some other goal, you can shift your asset allocation. You can move your assets into investments considered less risky, like bonds.
Finally, it’s important to note that, by default, you have a higher financial risk tolerance when you are younger. So when you’re investing in the long-term, you have an advantage when you’re just starting out.
What’s more, you can use dollar cost averaging to start building wealth, especially when you’re younger. That’s because you have time to recover from mistakes and market setbacks.
When you still have years ahead of you, a market drop offers a chance for you to buy low and ride out the storm.
Emotional risk tolerance
This is more about how you feel about risk. Some people really like taking risks. Others are more cautious.
Ultimately, the financial decisions you make due to your emotional risk tolerance can make a huge difference in your portfolio performance.
That’s why it’s important to pay attention to this aspect of investing because it can lead you into long-term portfolio problems.
For example, if you have a high emotional risk tolerance, you might be drawn to day trading, stock picking, and other types of investing with the potential for high returns.
Unfortunately, these types of investments also come with the risk of high losses. So if you don’t have the financial risk tolerance to handle your investing decisions, you could be in big trouble down the road.
On the other hand, it’s possible to be too risk-averse emotionally. If you have a very low emotional risk tolerance, you might not invest in assets that offer enough of a return to meet your goals.
For instance, the financial return from cash and bonds isn’t usually high enough to grow your wealth substantially. Unless you have a lot of capital to invest.
One of the reasons I like index funds is that they address most of the issues for those with high and low emotional risk tolerance.
Additionally, there are a number of investing tools available that can help you put together a portfolio that offers a good chance of adequate returns. Without being overly risky.
This doesn’t mean you can’t take a risk or two with your portfolio, though.
Once you have a good plan in place for building wealth in the long-term, based on your financial risk tolerance, you can take “extra” money and play around with it.
Find your risk tolerance
Figure out your own tolerance by thinking about how much you can afford to lose.
And, consider how nervous you get when your portfolio changes value. There are also a number of quizzes online that can help you find your risk tolerance.
You can find a risk tolerance quiz from Rutgers that makes you think about what you would do with money. And, how it makes you feel.
Or, take a look at a risk tolerance quiz through a robo-advisor website like Betterment when you sign up with them.
Once you understand what makes you tick, you can compensate and become a better investor.
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