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How To Determine Your Risk Tolerance

Investing Financial Planning Retirement Planning

Investing comprises a large portion of the financial landscape. From stocks to mutual funds to hedge funds to bonds, investing is a living and breathing entity resting on the shoulders of the economic marketplace.

Investing mechanisms are not all built alike. They vary in risk and reliability and cater to each user in a different way. What does investing look like to you? Having a clear statement on where you stand as a investor and the relationship you have with investing as a practice is a great start to further solidify your investing strategy. 

Like any strategy, the fluidity and movement lends itself to inherent risks. How equipped are you to take on these risks? Let’s find out. 

Risky Business

In order to determine your level of risk tolerance we first have to talk about the difference between risk tolerance and risk capacity. Though quite similar upon first glance, these two categories look to gauge different fundamental principles: want vs need. 

We have heard this distinction so many times. Do you want something or do you need something? You need water, but you don’t need a superhero glass to drink it out of. Thinking about risk tolerance and risk capacity is the classic struggle between want and need.

Risk tolerance is the ability of the investor to take on a particularly delicate investment. Risk tolerance is a changing variable, often depending upon age, income level, financial goals, and previous investment practice. 

Generally speaking, people who have more risk tolerance tend to be younger, ambitious people in the earlier years of their career. These people do not have as much to lose and everything to gain by taking on new investment strategies. Whereas people who are toward the end of their careers and nearing retirement often have a lower risk tolerance because they have much more to lose than they do to gain.

Risk tolerance is not a number nor does it fall on a scale. There are many ways to evaluate your risk tolerance including questionnaires whose main goal is to ascertain how much you are able to invest and still be able to function properly without excessive worry.

Risk tolerance is the want, whereas risk capacity is the need. Risk capacity is defined by the amount of money that the investor has to risk in order to meet their financial goals. The dependent variable, risk capacity relies upon the financial goals of the investor and what actions must be taken to get those goals accomplished. Another factor crucial to risk capacity is the rate of return on individual investments. This can be calculated by examining time frames and income requirements. This information will inform the investor of the kinds of investments that should be added to their profile in order to reach their goals. 

A Double Edged Sword

Some people are risk takers. They dive out of planes, open both eyes on the way down a roller coaster, arrive at airports less than an hour before their flights. Sometimes, these risks pay off and form valuable and wonderful experiences. You get the chance to fly, ride, and experience new wonders. It also could leave you running to the gate and arriving  just after the cabin doors have closed, out the money, and stuck at the airport. 

Risk is emotional. It can be exhilarating and relentlessly exciting but it can also be disheartening and disappointing. What is your relationship with risk? An honest assessment of this relationship is crucial to your success in investing. Ask yourself some questions: 

  • If the market drops, how will you handle it?

  • Do you have a contingency plan?

  • What are the potential losses and how will they affect you financially moving forward?

Let Reason Be A Guide

Inherently, risk accompanies investing. Use logical reasoning to help inform your financial risk decisions. 

  • How logical are your investments?

  • When will you rely on the money from these investments?

  • How much of your financial stability hangs upon these investments?

Lay out the facts and understand that your investment strategy will come with ebbs and flows. Even knowing that it is good to approach risk with a logical frame of mind. Even if you are a risk taker at heart, think about where you are at in life and who will be affected by your financial decisions.

Balancing Act

Even if some of your investments are deemed risky, it is important to assess your risk management when you go over your financial portfolio. Risk management seeks to determine the level of risk your investments carry and how to mitigate those so that you don’t get burned by too many losses. 

There is always a balancing act between the growth of your financial livelihood and your risk management. Let these two work together as often as possible, and you will find that you make well-informed financial decisions, even if they come with some risk.

Getting outside help from a financial advisor is a great step to help manage your financial risk. We would love to help you reach all of your financial goals. Give us a call!