November 04, 2019 | Category: Investments
When it comes to investing, everyone has a different risk tolerance. Your co-worker or neighbor may not give a second thought to an investment that leaves you with a sinking feeling in the pit of your stomach. But, risk tolerance isn’t a matter of “good or bad.” Whether you thrive on risks or avoid them at all costs, the important point is to know the level of risk that best suits you.
Investing typically involves a tradeoff between risk and return. Returns come in the form of interest or capital appreciation. Generally, the riskier an investment, the greater the potential return. This is because the market theoretically “rewards” investors for assuming risk, which is the potential for loss. Investors in pursuit of higher returns must be willing to assume the likelihood of loss associated with more volatile investments.
But, not everyone wants to take a higher risk in the hope of achieving a larger return. Some investors are perfectly satisfied receiving smaller returns on investments that carry lower levels of risk. The key is to find the right level of risk that potentially allows you to achieve your desired return—while keeping your stomach jitter-free!
What factors affect risk tolerance? Your age, stage in life, personal temperament, financial goals, and planning time horizon each play a role. Here is a brief discussion of these points:
Age and Stage in Life. Generally, the younger you are, the more risk you can assume. If you are single, you may be able to afford more risk than a married couple with children. And, if you’re just starting out in the work world, you may be more comfortable with higher-risk investments than if you are retired or approaching retirement.
Personal Temperament. At every stage of your investing life, it is important to evaluate how well you would handle the possibility of losing any funds you invest. Though you may find a roller coaster ride thrilling, you may not enjoy a wild market “ride.” The stock market, for instance, has historically risen over the long term, yet it has experienced wide short-term fluctuations. How well would you have handled the 1973 to 1975 recession, when the stock market dropped by 46%?
Financial Goals and Planning Horizon. It’s also important to consider how many years you have to meet your financial goals. Generally, the earlier you begin saving, the more risk you can afford to assume. Though you should never take on more risk than you are comfortable with, you should also recognize that the amount of risk you are willing to carry affects the return you can potentially expect to achieve. For example, if you take more risk late in life, you could have difficulty to recover after a loss.
Periodic Reviews—A Must
Knowing your “comfort level” for risk can prove invaluable when you must make investment decisions. With proper planning, you can develop a portfolio that balances your risk tolerance with your financial goals. Since risk tolerance changes with time and circumstances, make sure to discuss with your financial consultant these key areas to ensure your investment strategy and portfolio is aligned.
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