How to figure out your risk tolerance – and why

by Natalie MacLellan on May 10, 2011

in financial goals

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Your risk tolerance is the amount of investment risk you are comfortable with, or in other words: whether you are willing to accept a chance that some of your money might be lost in order to also have a chance at higher gains on that money.

Every investor has a risk tolerance that should not be ignored. A good financial adviser knows this, and will work with you to determine what your risk tolerance is and then to find investments that match your risk tolerance.

Figuring out your risk tolerance involves looking at several different factors. You need to know how much money you have to invest, what your investment and financial goals are, and how much time you have to reach them. Then you need to consider your personal characteristics: are you an adventurous and impulsive person who enjoys surprises; a methodical list maker, who plans and schedules all events months or weeks in advance; or somewhere between the two?

Conventional investing wisdom says that the more time you have to reach a goal, the more risk you can take. A young person planning for a retirement that is 50 years away can afford to take risks with their investments, because they have time to recover from potential losses. An older individual or someone planning for a short-term goal does not have the luxury of time, and so must be more careful.

This wisdom is based on a rational look at the markets and choices available, and does not take into account an investor’s personality, or feelings about money, which are also a huge part of their risk tolerance. How would that investor react if their portfolio was invested in stocks, and they had to watch the markets drop daily, for a week, month or much longer? Would they insist on selling, or sit back and let the money ride? This often has little to do with a person’s financial goals or investment choices – it comes down to how they feel about money.

For example, imagine two people planning to retire in ten years, who have no savings and no pension plan. An investor with a low to moderate risk tolerance will likely plan to put aside as much as possible every month, and invest it in a safe, low risk investment. There is no room in their plan for any investment losses. A person with a high risk tolerance might look at this situation differently, and put all their available money into a high risk investment, believing potential high returns are the only way to reach their retirement goals.

Neither approach is right. Neither is wrong. The low risk investor might not earn much income from their investments, but knows that whatever he is  able to save will be available for him in retirement. The high-risk investor wants to earn more and increase the amount of money available to her at retirement, but in doing so risks losing some or all of her savings. No one knows which investor will be better off, until the ten years are up.

Again, a good financial adviser will help you determine the level of risk that you are comfortable with, and help you choose your investments accordingly. Your risk tolerance should be based on a compromise between what your financial goals are and how you feel about the possibility of losing your money. The two cannot be separated.

For more guidance, our friends at (the BC Securities Commission) have created a risk test. Try it!

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