When it comes to investing, the higher the risk the better the reward. But what if you don’t know what your risk level is? Your risk tolerance is the level of risk you’re willing to take with your investments. You can determine your risk tolerance by evaluating your comfort level in certain investments. Before you get started with investing, learn how to choose securities that suit your risk tolerance.
What Is Risk Tolerance?
Risk tolerance is the amount of risk you can tolerate, such as volatility in the market or what stock prices suddenly go up and down. When you create an investment portfolio, you’ll be asked a few questions to determine your risk tolerance. Many robo-advisors ask an online questionnaire to gauge your tolerance. If you open an account with a brokerage firm or an investment company in person or over the phone, a financial advisor or broker may ask you a few questions.
A few factors like where you are in your life, your age, job and family status, can help determine your risk tolerance. For example, the older you are, the less riskier you might be when it comes to your investments. You may cash out sooner as you head into retirement, and you may not want to end up with less cash when you aren’t earning as much as you used to.
Your risk tolerance helps guide your entire investment strategy. The investments you choose come from how risky you are. For instance, stocks are riskier investments, but they tend to have a higher rate of return. If you’re riskier, you may invest in more stocks as opposed to other types of investments. If you’re not as risky, you may look into index funds or money market accounts, which have lower risk and you may not need as much money to get started.
How Is Risk Tolerance Calculated?
Your risk tolerance calculation comes from your age, major life changes (like if you’re going to buy a home soon), income and investment comfort level. Regardless of where you open an investment account, you’ll need to share major financial details to discover your risk tolerance.
Aside from finances, most questionnaires want to learn how you’ll handle potential losses. A New York Life Investor Profile asks, “Due to a general market correction, one of your investments loses 14% of its value a short time after you buy it. What do you do?”
You could sell the investment so you don’t risk losing any more money. Or you could hold onto the investment and wait for it to recoup its losses. You could also buy more of the same stock, now at a lower price than when you bought it.
There is no wrong answer here. The answer is what’s best for you, your risk tolerance and your financial goals and obligations. However, it’s also important to know that every investment comes with some level of risk.
What’s Your Risk Tolerance?
The questionnaire you complete will help guide you in the right investment direction. Before you take it, though, see what profile you might get. We list a few outcomes below.
- Super cautious
- Against losing any money
- Will need money in the short-term, which is typically defined as less than five years
- Willing to invest in some risky products but not the majority
- Modest level of appreciation in portfolio
- Minimal volatility
- Decent balance between a stable portfolio and appreciation
- Happy with a limited amount of risk and the upcoming return
- Invests mostly in stocks and is looking to increase diversification
- Mostly invested in stocks and equities
- Accepts market drops in pursuit of long-term gains
- Won’t use money for at least a decade or longer
- High return expectations, with 90% or more of investments in stocks
- Expecting to use money in 15 years or longer
The Bottom Line
Your investment strategy is based off what you’re comfortable with contributing as well as what you’re willing to accept in return. If the idea of losing any money is scary to you, it’s likely you have a conservative risk tolerance. If you believe in trying to reach the highest return possible – even if it means you could lose money – you’ve got a more aggressive investment strategy.
Keep in mind that your risk tolerance is fluid. It may change based on your salary, disposable income and age. If you’re early in your career and don’t have a lot of expendable cash, you may be somewhat moderate in your investments. As you earn more money, you might become more aggressive. But as you get older and see retirement on the horizon, you may become more conservative. You will likely change your asset allocation based on your ever-evolving risk tolerance.
Tips for Investors
- When it comes to investing, risk tolerance is just one factor. You should also consider how long your investments will have to grow. If you’re in a position where you could invest, you should start as soon as you can. Many people invest for their future, and this retirement calculator can show you why it’s best to invest early and often if you want to retire the way you want.
- Managing an investment portfolio requires thorough research, which can be time-consuming. Keeping up with the markets also requires background knowledge, and it may be easier for someone with access to reports, financial statements, analytics data and advanced financial modeling software. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
- If you’re low on cash but willing to take the risk on earning big with strategic investments, consider hiring a robo-advisor to help manage your account. Many have no or low opening balance minimums. They also tend to charge lower fees than other types of money managers. Despite the more affordable price point, some services still provide working sessions with human advisors.
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