Risk tolerance is a topic that is often discussed, but rarely defined. It is not unusual to read a trade recommendation discussing alternatives or options based on different risk tolerances. But how does an individual investor determine his or her risk tolerance? How can understanding this concept help investors in diversifying their portfolios? Read on as we delve into this concept. (To learn more, read Determining Risk And The Risk Pyramid.)

Risk Tolerance by Time frame
An often seen cliché is that of what we'll refer to as "age-based" risk tolerance. It is conventional wisdom that a younger investor has a long-term time horizon in terms of the need for investments and can take more risk. Following this logic, an older individual has a short investment horizon, especially once that individual is retired, and would have low risk tolerance. While this may be true in general, there are certainly a number of other considerations that come into play. (For related reading, see The Seasons Of An Investor's Life and Portfolio Management For The Under-30 Crowd.)

First, we need to consider investment. When will funds be needed? If the time horizon is relatively short, risk tolerance should shift to be more conservative. For long-term investments, there is room for more aggressive investing.

Be careful, however, about blindly following conventional wisdom. For example, don't think that just because you are 65 that you must shift everything to conservative investments, such as certificates of deposit or Treasury bills. While this may be appropriate for some, it may not be appropriate for all - such as for an individual who has enough to retire and live off of the interest of his or her investments without touching the principal. With today's growing life expectancies and advancing medical science, the 65-year-old investor may still have a 20-year (or more) time horizon.

Risk Capital
Net worth and available risk capital should be important considerations when determining risk tolerance. Net worth is simply your assets minus your liabilities. Risk capital is money available to invest or trade that will not affect your lifestyle if lost. It should be defined as liquid capital, or capital that can easily be converted into cash.

Therefore, an investor or trader with a high net worth can assume more risk. The smaller the percentage of your overall net worth the investment or trade makes up, the more aggressive the risk tolerance can be.

Unfortunately, those with little to no net worth or with limited risk capital are often drawn to riskier investments like futures or options because of the lure of quick, easy and large profits. The problem with this is that when you are "trading with the rent" it is difficult to have your head in the game. Also, when too much risk is assumed with too little capital, a trader can be forced out of a position too early.

On the other hand, if an undercapitalized trader using limited or defined risk instruments (such as long options) "goes bust", it may not take that trader long to recover. Contrast this with the high-net-worth trader who puts everything into one risky trade and loses - it will take this trader much longer to recover.

Understand Your Investment Objectives
Your investment objectives must also be considered when calculating how much risk can be assumed. If you are saving for a child's college education or your retirement, how much risk do you really want to take with those funds? Conversely, more risk could be taken if you are using true risk capital or disposable income to attempt to earn extra income.

Interestingly, some people seem quite alright with using retirement funds to trade higher-risk instruments. If you are doing this for the sole purpose of sheltering the trades from tax exposure, such as trading futures in an IRA, make sure you fully understand what you are doing. Such a strategy may be alright if you are experienced with trading futures, are using only a portion of your IRA funds for this purpose and are not risking your ability to retire on a single trade.

However, if you are applying your entire IRA to futures, have little or no net worth and are just trying to avoid tax exposure for that "sure thing" trade, you need to rethink the notion of taking on this much risk. Futures already receive favorable capital gains treatment (60% long term, 40% short term); capital gains rates are lower than for regular income, and 60% of your gains in futures will be charged the lower of the two capital gains rates. With this in mind, why would a low net worth individual need to take that much risk with retirement funds? In other words, just because you can do something doesn't always mean you should. (For related reading, see A Long-Term Mindset Meets Dreaded Capital Gains Tax.)

Investment Experience
When it comes to determining your risk tolerance, your level of investing experience must also be considered. Are you new to investing and trading? Have you been doing this for some time but are branching into a new area, like selling options? It is prudent to begin new ventures with some degree of caution, and trading or investing is no different. Get some experience under your belt before committing too much capital. Always remember the old cliché and strive for "preservation of capital." It only makes sense to take on the appropriate risk for your situation if the worst-case scenario will leave you able to live to fight another day. (To learn more, see A Guide To Portfolio Construction.)

Careful Consideration of Risk Tolerance
There are many things to consider when determining the answer to a seemingly simple question, "What is my risk tolerance?" The answer will vary based on your age, experience, net worth, risk capital and the actual investment or trade being considered. Once you have thought this through, you will be able to apply this knowledge to a balanced and diversified program of investing and trading.

Spreading your risk around, even if it is all high risk, decreases your overall exposure to any single investment or trade. With appropriate diversification, the probability of total loss is greatly reduced. This comes back to preservation of capital.

Knowing your risk tolerance goes far beyond being able to sleep at night or stressing over your trades. It is a complex process of analyzing your personal financial situation and balancing it against your goals and objectives. Ultimately, knowing you risk tolerance - and keeping to investments that fit within it - should keep you from complete financial ruin.

(For related articles, visit How Risky Is You Portfolio? and Do You Understand Investment Risk?)

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