Determining Your Risk Tolerance
Do you want a high-speed trip or a slow-and-steady ride from your investments?
Your risk tolerance can help you determine which investments are right for you.
Does your ideal Sunday afternoon involve a slow walk around the block or zipping around hairpin turns on a vintage Ducati? In either case, you’ll go on a journey, but one or the other might be a better fit for your personality and needs. In investing, your risk tolerance helps determine whether you’d be better off with steady-moving investments or investments that give you a more intense ride.
How do you figure out your risk tolerance and why does it matter?
With investing, you typically face a trade-off: Investments that have the potential to return a lot also usually involve more risk, which can give more turbulent rides. But smoother, less volatile investments may not return enough to get you where you want to go. Figuring out your risk tolerance is a way of working out which types of investments are best for you. (Spoiler alert: Most people end up somewhere in the middle.)
There are three main factors that go into determining your risk tolerance:
- Time horizon. This refers to how long you plan to hold your investments. If you need your money soon, such as within the next three years, then you probably want to hold it in more stable investments because your portfolio might not have time to recover if the market stumbles. If you’re investing for something that’s decades away, such as retirement, you can probably take on more risk.
- Goals. What are the specific goals you have for investing? Is it to buy a house or put away money for your children’s education? If you need more growth to reach your investing goals, you might need to take on more risk.
- Your “risk appetite.” How much risk can you tolerate? If flying gives you a panic attack, then you might be more of a driver. Similarly, you only want to own investments that you could live with even when the market hits some turbulence.
All investments come with different types of risk.
Every investment faces a number of risks. With stocks, there’s the risk that a news headline spooks the market. With bonds, different economic environments and changing interest rates can send prices up or down. And two different stocks or two different bonds can have very different risk profiles. It’s incredibly important to make sure you understand all the risks before you invest.
That said, the simplest way of thinking about risk is in terms of “volatility” — that’s a way of describing how bumpy your ride is likely to be with different investments. More volatile investments tend to reach higher highs and lower lows, while less volatile investments typically don’t experience such severe extremes. Here’s a basic way of thinking about it:
- Cash. Cash gives you a gentle ride, like a leisurely walk, but it might not return enough to always get you where you need to go, and it can lose value to inflation over time.
- Bonds. Bonds generally give a smoother ride than stocks, but just like a bicycle they can hit the occasional wobble, and they’re not immune to suffering losses.
- Stocks. Investing in stocks can be like riding in a jet. Stocks may go through some choppy ups and downs but can offer faster potential growth than the alternatives.
A diversified portfolio made up of a mix of stocks and bonds can offer better returns than bonds alone but with less turbulence than a portfolio of just stocks. Many investors find this is in their comfort zone – like taking a drive in a sensible car.
Your portfolio should take on the amount of risk that’s right for you.
Once you understand how much risk to take on, you can put together a portfolio. For many investors, it makes sense to hold a mix of stocks and bonds. Portfolio mixes may include
- Conservative: Since they hold mostly bonds, these portfolios should provide fairly steady rides, with returns primarily generated from income.
- Moderate: With a mix of stocks and bonds, these portfolios should offer both growth and income with some stability.
- Moderately aggressive or growth: Consisting of more stocks than bonds, these portfolios may offer greater long-term growth but may also hit some bumps along the way.
- Aggressive: These portfolios hold mostly stocks with returns primarily generated from capital appreciation, and might be right for you if you’re investing for a long-term goal and can handle an unpredictable ride.