Creating a financial nest egg to live comfortably is essential for many people -- especially when it can help them survive turbulent economic conditions such as those brought about by the COVID-19 pandemic or the last big national recession.
There are many ways you can invest money as you seek to build a sound financial future. However, risk is a dominant factor in every investment decision you’ll make. Your tolerance for risk, or the amount of financial uncertainty you’re willing to take on in regards to your investments, will both guide your investment decisions and dictate expected returns on those investments.
Why is Risk Tolerance Important in Investing?
Risk tolerance is the amount of losses you can potentially absorb when you make investment decisions -- in other words, it’s your willingness to take on risk. Risk and reward go hand-in-hand in investing, regardless if you are funding a startup, purchasing blue-chip stocks, or certificates of deposit (CDs). Understanding your tolerance for risk can help you make more prudent decisions as you plan your investment portfolio.
There are many factors to consider when assessing your risk tolerance, including:
- Investment horizon
- Size of your portfolio
- Your appetite to assume risk, which ranges from aggressive to conservative
- Financial/Investment goals
Let’s take a closer look at each.
AGE. Historically, risk tolerance is closely tied to age -- younger investors have a longer timeline to wait for their investment decisions to pan out or to ride out cyclical market downturns. It’s also why many older investors reconfigure their portfolios as they near retirement and afterwards in an effort to protect principal and manage risk. However, age might not play much of a factor for high-net-worth individuals who have amassed enough capital to tolerate greater levels of investment risk.
TIMELINE. Your investment timeline is dictated by your financial goals and the amount of time you are willing to have investment capital tied up. You’ll need to consider how much money you hope to amass, when you expect to need it, and how long it’s supposed to last. These factors are unique to nearly every investor, and risk poses a much greater threat to financial goals the closer investors get to the end of their investment timelines. Investment horizon and risk tolerance often don’t work in lockstep.
PORTFOLIO SIZE. Investors with greater net worth typically can take on a higher degree of risk tolerance since they can “afford” to lose their capital if their investments sour. Losses likely won’t affect them as much as retail investors who’ve leveraged a portion of their capital for investment purposes.
APPETITE FOR RISK. Aggressive investors are comfortable assuming a higher degree of risk than conservative investors. The tradeoff is the potential for greater yield on their investments. Conservative investors, meanwhile, are more comfortable trading lower yields for investments that can maintain their original capital and potentially return more modest gains. Moderate investors, meanwhile, straddle the middle ground between the two.
FINANCIAL GOALS. Your financial goals are closely tied to your tolerance for risk. Tolerance is generally higher for long-term financial goals such as retirement because your investments have more time to mature and recover from market downturns. Short-term financial goals, such as saving for your child’s college education, generally have lower risk tolerance since you’ll need that capital sooner.
There are many other factors that can dictate your risk tolerance in investing, such as availability of capital, negative changes in your health, major life events such as marriage, divorce or having children, employment, and more.
Putting it All Together
The symbiotic relationship between risk, financial goals, age, and other factors can be murky. Your ability to judge your tolerance for risk against your financial goals and investment time frames are keys to successfully navigating important investment decisions. While many investors figure out these crucial aspects of successful investing on their own, others rely on financial planners and investment advisors to help them determine the clearest path forward.
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