Risk tolerance: what is it and why it matters

Risk tolerance is the ability to bear losses when your investments are performing poorly. If you buy stocks, for example, how much fall in the market can you take?

If your tolerance is low, you will invest prudently. For example, a larger portion of your portfolio may be made up of lower risk bonds and a smaller portion of higher risk stocks.

Knowing your risk tolerance helps create a game plan. In many ways, this will determine how you invest, says Marianela Collado, certified financial planner and co-owner of Tobias Financial Advisors in Plantation, Florida.

Risk tolerance factors

“Everyone’s risk tolerance will be different,” says Charlie Horonzy, certified financial planner and founder of Focused Up Financial in Chicago.

Here are some of the determining factors:

Goals: The whole point of financial planning is not to accumulate as much money as possible. It’s about deciding what you want out of life, figuring out how much money you need to meet those goals, and then choosing an investment strategy that will deliver the appropriate returns.

Chronology: In general, you can take more risks if you have a lot of time to get over the bumps. “If you need money in five or 10 years, it’s a lot different than if you’re 15 or older,” says Horonzy. The overall trajectory of the stock market over the decades is up, but there are lows and plateaus. A 30-year-old who is saving for retirement at 65 has plenty of time to wait. But if you are saving to buy a house in a few years, investing that savings in stocks is too risky because there probably won’t be enough time to recoup the losses if the stock market falls.

Age and stage of life: “If you are 80 years old, this tolerance may not be as high as it would be for someone in their 30s,” Collado says. At 30, you have time not only to overcome volatility, but also to earn more money by working.

Wallet size: Someone who starts retirement with a $ 5 million portfolio may be able to take more risk than someone with $ 500,000, Collado says. The person with the largest portfolio has more cushion if values ​​fall.

Personal comfort level: Some people are naturally more comfortable taking risks than others. “I always tell people, ‘You have to be able to sleep at night,’” says Collado. If the market’s volatility is too stressful, it’s a signal that you need to better understand what to expect or be into less risky investments, she says.

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The risks of ignoring risk tolerance

Investing without considering tolerance for risk is like sleepwalking on the edge of a cliff. Imagine investing in stocks without thinking about how you will react if their value goes down.

“You’re going to wake up really quickly when the market goes down,” says Horonzy.

A great danger is then to panic and flee the market. Then, “you fall into the # 1 investment mistake of selling cheap,” says Nora Yousif, chartered financial planner and vice president of RBC Wealth Management in Boston. A fall in the market is actually a buying opportunity because the prices are falling.

Another danger is playing too cautiously, says Yousif. You are not taking enough risks to achieve your goals. Taking a slightly more aggressive position for better returns can make a huge difference in the long run.

Take a look at the difference a 1% annual return can make for a one-time investment of $ 100,000 after 35 years:

What is my risk tolerance?

Automated investment services called robo-advisors (as well as human financial advisers) ask clients to fill out questionnaires to help them assess their risk tolerance. (If you’re just starting out or don’t have a lot to invest, a robo-advisor is an inexpensive way to start. Check out our best choices for robo-advisers.)

Answer questions about risk honestly – not the way you would a smart investor.

You answer questions like this from Vanguard:

“During market downturns, I tend to sell parts of my riskier assets and invest the money in safer assets.” Possible answers: Strongly disagree, disagree, somewhat agree, agree, strongly agree.

Answer questions about risk honestly, not like you would a smart investor.

Take our quick Risk Tolerance Quiz to start exploring your attitude to risk taking. The quiz is not meant to guide investment choices – you will need to consider your goals, timing, and other factors before making any investment decisions – but it can give you insight into your trends. natural.

Take the risk seriously

In addition to evaluating questionnaire responses, human financial planners say they spend a lot of time talking about risk so clients aren’t caught off guard when values ​​drop.

“No one is complaining about the rise in value,” Yousif says. But it’s natural to wince when the market goes down and your wallet shrinks. She emphasizes the normalcy of stock market volatility and helps clients mentally prepare themselves so they can hang in when things go wrong.

“It’s one thing to guess how you’re going to handle a loss, and it’s another to assess after losing 12%,” Yousif says. She converts percentages to real dollars when she talks about what to expect if the market goes down. “It tends to grab people’s attention. “

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