It’s easy to feel confident in your investment strategy when the market is performing well, but the reality is that the market moves up and down in cycles over time. That’s why it’s important to understand your risk tolerance – because it helps you decide how much risk you take.
We can help you get a better understanding of risk tolerance and how it can affect your strategy.
Two factors work together to determine your risk tolerance – your willingness and ability to take risk.
Your willingness to take risk is tied to your personality and how much you’ll worry about your investments1. If you’re the type of person who may worry when the market changes, you probably have a lower risk tolerance. This means you’d prefer investments that are less likely to lose money but offer lower return.
If you’re willing to leave your money alone and stick to your long-term investment plan through ups and downs in the market, you probably have a higher risk tolerance.
If you aren’t sure what you’re comfortable with, ask yourself:
- When do I need the money I’m investing? In the short-term or long-term?
- How would I react if my investment dropped significantly in value?
Getting a handle on your risk tolerance can help prepare you for changes in the market and can save you a lot of stress. And if you have more questions, you can talk to an advisor for more help.
Your timeline also plays a big role in your investment strategy. The younger you are, the more time you have to recover from market downturns – particularly when it comes to your retirement goals. If you’re in your 20s and are saving for retirement, you should be able to handle short-term changes in your investments.
Factors beyond just your timeline, like your income and other assets, also play a role in your ability to take on risk.
That’s what “risk capacity” is – your ability to survive financial loss if your investments take a steep drop. If you have a higher risk capacity, this means you can stay the course and hopefully rebuild your assets over time if the market takes a significant drop.
If you have a lower risk capacity, you would be majorly impacted if the market dropped. For instance, if you’re about to retire, you probably wouldn’t want to put a big chunk of your savings into a risky investment.
That’s why it’s important to check in with your advisor as your life changes.
Risk tolerance comes down to your psychological makeup and preferences and your real-world financial situation. It’s important for these two areas to line up. If you’re very willing to take risk, but unable to recover from market drops, you could run into real challenges. And vice-versa.
Once you determine your risk tolerance, you’ll be able to choose a strategy for your investments2. There are typically three strategies:
- Conservative: your tolerance and capacity are lower. This strategy might include fewer stocks and more bonds or money-market assets (which usually offer steady returns with less fluctuation in price).
- Moderate: you might be somewhere in the middle, perhaps someone with a higher risk tolerance but a lower risk capacity. This strategy might include a mix of stocks and bonds to uphold a more balanced approach.
- Aggressive: you have a higher risk tolerance and higher risk capacity and accept that you might see big swings in the value of your investment over time. You’re also looking for the potential of bigger returns. This type of strategy tends to be made up mostly of stocks (as opposed to bonds) from big and small companies.
You’re in control of assessing your tolerance and ultimately, for how much risk you take. But you don’t have to do it alone – there are experts who can help. Talk to your advisor to make sure your strategy matches your risk tolerance and needs.
1 https://www.wiselyadvised.com/bewise-blog-by-wisely-advised/understanding-your-risk-toleranceOpens a new website in a new window - Opens in a new window
2 https://www.thebalance.com/what-is-risk-tolerance-2466649Opens a new website in a new window - Opens in a new window
This information is general in nature, and is intended for informational purposes only. For specific situations you should consult the appropriate legal, accounting or tax advisor.