In investing, the term “risk tolerance” refers to your ability to tolerate losing money on an investment. Traditionally, the typical investor has been encouraged to calculate his or her risk tolerance based on his or her age. According to this model, a 25-year-old investor has a higher risk tolerance, because he or she has decades in which to recoup the losses. A 55-year-old investor, on the other hand, is nearing retirement and may want to take a more conservative approach.
When you start to explore investing and personal finance in detail, however, you realize that it isn’t that simple, especially these days. Today’s young investor may not have the capital his or her parents did at his or her age; today’s older investor can look forward to a much longer retirement due to increasing life spans. Your true risk tolerance will depend not just on your age or the amount of capital you have available, but on your financial goals, your investment experience, the investment itself and, in no small part, your feelings regarding financial risk.
High-Risk vs. Low-Risk Investments
The amount of risk an investment carries is determined by the likelihood of that investment leading to financial losses. High-risk investments include futures and options — investors often lose out on these sorts of investments. Low-risk investments are those that are all but guaranteed to bring a return. Money-market bank accounts, savings accounts, certificates of deposit and government or municipal bonds are all considered low-risk investments. There’s a chance you might lose money on these investments, but it’s very small; your bank or government would have to fail first, in which case you’d have bigger problems than losing your savings.
The trouble with low-risk investments is that they bring low returns. Higher risk brings higher returns. That’s why many people, especially those with little capital, feel compelled to invest in high-risk ventures. They’re lured by the promise of great returns. But if you’re one of the many who want both good returns and manageable risk, you’ll choose a middle-risk investment, like stocks, mutual funds or real estate.
Calculating Your Risk Tolerance
Before you can calculate your risk tolerance, first determine your goals and the time frame you have in which to achieve them. If you’re saving for retirement and you’re still two or three decades away from that goal, you may indeed have a high or very high risk tolerance.
On the other hand, if you’re about to retire but you don’t have enough money saved up, an aggressive approach may still make sense for you, especially considering that you may have 20 or 30 years of life left. If you’re saving for a house down payment or your kid’s college tuition, you may want to take less risk with that money. By the same token, if you want to save for a goal that’s fewer than five to 10 years in the future, you should take a more conservative approach. The longer your investment timeline is, the better your chances of recouping any losses.
Consider Your Earning Power
You should also consider your net worth and your ability to recover financially from any losses in calculating your risk tolerance. You should never invest money you can’t afford to lose; you may be forced to sell out of your position too early in order to meet your need for cash.
You may think that having little capital means you have little risk tolerance. Not necessarily. It depends on your earning power; if you can rebuild your small amount of capital fairly quickly, you can stand to lose some or all of it. You actually have a higher risk tolerance than someone with a lot of capital and little earning power, who could suffer total financial ruin over a single ill-advised trade. That said, you should always research every investment and get professional advice if necessary to make certain that your investments are sound. If you have little or no investment experience, you shouldn’t trade aggressively until you do.
Evaluating Your Personal Comfort Level
The final piece of the puzzle lies in your feelings about assuming financial risk. Many people are very uncomfortable with assuming financial risk, and understandably so. Your feelings regarding financial risk will very likely change often, depending on how the markets are doing and where you are in your own financial life. You may feel very comfortable assuming a lot of risk one year, only to do an about-face the next year when the markets do poorly or a financial calamity strikes your household.
It can be difficult striking a balance between what you’re comfortable with and what will bring you the highest returns. That’s why you should always diversify into both low and middle-risk investment options, whether or not you’re comfortable with high-risk investing. If you’re uncomfortable with high risk, you’ll get a feeling of security; if you’re comfortable with it, you’ll be able to more easily weather the possible fallout of risky investment decisions.
Many factors go into determining a person’s risk tolerance; it’s not as simple as it might first appear. But you need to know what your tolerance for risk is before you start investing, and you need to reevaluate it regularly. Otherwise, you could sell yourself short of some great returns.