How to Determine the Investment Portfolio That Reflects Your Risk Tolerance
The first step in any investor’s journey is identifying what your risk tolerance is when it comes to investments and your money.
Investors are generally grouped into three types of risk categories – high, moderate, or low. These categories help determine how much risk you are prepared to handle. Are you more comfortable growing your portfolio by investing your money in higher-risk investments knowing you can withstand a financial loss should it occur? Or do you value low-risk investments as you navigate a significant change in your life? Maybe you are comfortable with moderate risk tolerance, or so new to investing that you are not sure what your risk tolerance is.
Here are some factors to help you understand what type of investor you are and how to build your asset allocation strategies:
Familiarity with Investing:
Your Knowledge of how the market works is a factor in determining your investment strategy and into which category you should consider placing yourself. Well-versed investors may feel more comfortable making high-risk investments resulting in higher returns. Those with little investment knowledge would fare better approaching the market with a low-risk tolerance. In other words, they rather invest their money in bonds than purchase high-risk stocks.
If you are someone who has shied away from the investment because it is complicated, intimidating, or boring, you are not alone. Only about half of Americans invest in stocks, according to the Federal Reserve System. But starting with a good understanding of investing terminology and trusted guidance can ease those worries.
As it relates to knowledge, your risk tolerance may change over the years, based on where you are in your investment learning journey. While some investors rely on financial advisors who do the work for them, other people gain a better understanding of the system working alongside experts as they learn.
Understanding Your Timeline
When determining your risk tolerance, one of the main things to consider is your time horizon; meaning how much time you have to not only grow your money in the market but also recover from any declines or losses you may experience when the stock market dips.
According to the U.S. Securities and Exchange Commission, investors who have long-term financial goals, or those who have more time to invest and possibly recover tend to have a higher risk tolerance, and may benefit financially more from high-risk assets. Those long-term investments can include:
- Real Estate
However, investors who are nearing retirement or are not looking to stay in the market for long should value low-risk cash investments such as:
- Certificates of Deposits (CDs)
- Money Market Account
- Treasury Inflation-Protected Securities (TIPS)
- Corporate Bonds
- Purchasing Power
The amount of money investors are willing to invest can influence your financial risk tolerance. Those who have a larger portfolio can take more risks because the overall percentage loss is less. For example, a portfolio with $100,000 in assets may have a different risk tolerance than a portfolio worth only $10,000.
Having a successful investment strategy and portfolio with the highest return potential is ideal, but it may not be the only deciding factor in determining your overall risk tolerance. It’s important to consider all the factors and how they relate to your situation.
Age and Circumstances:
There is no one-size-fits-all strategy when it comes to assessing your risk tolerance level, but there are some factors that may sway you into a certain category, including your age.
When considering longer-term investments, it is reasonable to assume that younger investors can be viewed as high-risk investors or an aggressive investment strategy because they have a long time horizon (usually years) to recover from stock market volatility. Those who are in the middle of their careers may have a more conservative risk tolerance, select less-risky investments, and be considered conservative investors or aggressive investors depending on their risk capacity and how the other risk factors affect them. Those who are approaching retirement or have hit retirement age may have a shorter time horizon, low-risk tolerance, and consider low-risk investments unless they already have a high-performing portfolio giving them higher potential returns.
Aside from age, life circumstances should also be considered. When considering financial goals, factor in the life changes for which you are financially preparing. Those could include:
- Buying a home
- Having children
- Education Expenses
- Career Change
There are a lot of resources available that offer a risk tolerance quiz or risk tolerance assessments to help you determine your risk profile and how comfortable you are with taking risks. But no one knows you best. Think about the times you’ve passed by a casino and shuttered at the thought of slipping a $20 bill into a slot machine. Or maybe you are the high roller at the craps table which has a good time even if you lost.
How you value money, the loss of it, and the returns, are key takeaways to consider when assessing your investment risk tolerance. Knowing if you are the type of investor who always plays it safe or someone who takes big risks and can deal with any negative consequences can help you tap into the investment strategy that will work best for you.
Risk Tolerance Can Change Over Time
Assessing your risk tolerance when it comes to your investments is an ongoing mission because, as years go by and life happens, your risk tolerance may change. Just as it is important to identify those factors from the beginning, you should regularly assess and re-evaluate to see what may have changed.
Perhaps you’ve settled into a low-risk category, but you realize that after some time, you’re much more informed about investing, your portfolio is strong, and you are more comfortable with higher-risk assets. Conversely, maybe you find that your high-risk strategy is no longer conducive to your financial goals.
The beauty of taking control of your financial future is understanding your investment goals and the opportunity to figure out how the tolerance factors may work for you or against you at any given time.
Investment doesn’t come without risk, regardless of the level you fall into. However, making investments with your money that align with your risk tolerance, especially with the help of experts and investing models can help you comfortably grow your future wealth.