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(ARTICLE) Understanding Your Risk Tolerance When Investing

Added 2022-05-11 10:15:49 +0000 UTC

The higher the risk, the bigger the potential reward. But that relationship goes both ways.

The more risk you take when you invest, the more you expose your portfolio to greater volatility and chance of loss.

When it comes to investing, you need to balance your desire for a high return with your ability to handle risk and the potential of losing money in the market.

Assessing Your Risk Tolerance

When it comes to investing, risk and reward go hand in hand.

The phrase “no pain, no gain” comes close to summing up the relationship between risk and reward.

Don’t let anyone tell you otherwise, all investments involve some sort of risk.

An aggressive investor, or one with a high risk tolerance, is someone who is willing to risk losing money to get potentially better results.

A person with a lower risk tolerance will favour investments that maintain his or her original investment.

Investing your money is one of the most important ways you can improve your finances and build financial abundance.

In fact, if you only focus on saving and never investing, your money is going to lose it's value due to inflation, and as a result you could struggle to keep up with the cost of living.

Inflation is when the cost of living increases. So if you don't have money working for you whilst living cost increase, then the only way you'll be to keep up would be having to earn more money in your career or business.

Risk tolerance is your ability to handle the ups and downs that occur in the financial markets.

But investing comes with its own set of challenges. When you put your money into the stock market, you could potentially lose some of your investment. Before you get started, you need to know how comfortable you are with the risks.

Risk tolerance is a measure of your ability to comfortably stomach losses, and it’s very different for everyone.

This is why it’s important to not just copy another person’s investment portfolio — they may be more or less comfortable with riding out heavy losses compared to you.

Also keep in mind that your financial goals, and your risk tolerance, can also be tied to your financial security.

You might feel more inclined to take on more risk if you have a stable income, little (or no) high-interest debt.

If you’re not struggling to cover for expenses, then you might not worry as much if your investments take a dip because you’re not relying on that income.

If you don’t have the stomach for dealing with the risks of losing your principal, even temporarily, you’ll have to settle for lower risk investments and the lower returns that come with them.

Investments with the potential for higher returns often come with a higher potential for sudden downdrafts or outright losses.

With an understanding of your risk tolerance, you can then create a strategy for your investments that will help you balance the worries of volatility with the potential for bigger returns when looking at the large picture.

How risk tolerance works

Anyone can have a high risk tolerance when stocks are rising. However, the best time to truly assess your risk tolerance is when the market is falling.

"Everyone is a great investor during a bull market"

A "Bull market" is when the entire economy is doing great and the stocks, crypto and real estate are doing all time highs, so people start thinking they are great investors when they get in during a bull market and all their investments are doing great from the get go.

A Bear market is when it's doing the opposite. All the market is in the red, prices are stagnant and declining.

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.

Anyone can have a high risk tolerance when stocks and crypto are rising. However, the best time to truly assess your risk tolerance is when the market is falling.

Think back to March 2020. (Covid)

The market tanked

People were loosing their jobs overnight.

This lead to A LOT of people being fearful and being in uncertainty and were wondering if COVID would destroy the economy going forward.

What was your risk tolerance then?

Did you hang on through those tough times?

If you sold stocks during the panic, your risk tolerance was low.

Or were you willing to invest more to take advantage of the market sell-off?

If so, your risk tolerance was high,

and it had served you well as the stock and crypto market had set record-breaking numbers and new all time highs about 7 months after the pandemic had came.

Types of risk tolerance

Conservative risk tolerance

With this mindset, you are more focused on preserving your initial deposit and the avoidance of downside risk.

That means lower returns, but then you will settle for that in exchange for steering clear of any wild swings in the market.

The promise of the return is a pro, but the low earning potential can be a drawback.

An older person who is closer to retirement will be most likely have a conservative risk tolerance.

Moderate risk tolerance

Moderate risk tolerance keeps a foot in two sides: conservative and aggressive.

For example, this is when a person has a 60/40 allocation between stocks and crypto (or between any other 2 different investments)

This makes a balance between some money invested for growth while maintaining an eye on stability for income generation at the same time.

Aggressive risk tolerance

With an aggressive risk tolerance, the majority of a person's investment portfolio is allocated toward riskier assets such as Crypto, Nft's, Real Estate, Individual stocks.

These offer the possibility of higher returns over time.

There is no guarantee that an investor will actually get the money back.

Being aggressive means being willing to accept the chance you will lose some or all of the initial investment.

How would you react if your portfolio lost 20 percent this year?

Assessing your risk tolerance involves thinking about hypothetical challenges and worst-case scenarios.

If your investment lost 20 percent of its value, would you lose sleep at night and pull out all of your funds? Or would you leave it invested and consider putting even more money in the market to capitalise on the discount?

When you’re early in your career and new to investing, it’s important to have a long-term vision.

It can be tough watching your investments decline from one day to the next.

However, if you aren’t investing that money for tomorrow or next month, you have to recognise that it’s the end game that really counts.

The stock market has average of a 10% return, but it doesn’t deliver those 10 percent gains every year.

Some years, it may be down more than 30 percent, whereas others, it might be up more than 30 percent.

Measure the growth of your returns over time — not every single day. (unless it's a very high risk investment like crypto)

If your risk tolerance is too high...

If you're overly aggressive when it comes to taking on risk, you could put yourself in a position where you can't recover the money you lose. You need a lot of capital and a long time horizon if you want to take big risks.

Taking on huge risks in the hopes of massive returns may not be a problem if you're young and early in your career.

However, if you're approaching retirement or may want to use the money in your investment portfolio within the next five to 10 years, lower down the risk you take and consider playing it a little safer so you don't fail to miss your financial goals because you lost money in the market.

If your risk tolerance is too low...

On the other hand, you have to be careful with how safe you play it. If your risk tolerance is too low, you could miss out on the chance to build the wealth you need to retire when (and how) you want.