What Is Your Risk Tolerance?

AAA

It is conventional wisdom that a younger investor can take more risk than an older investor thanks to a longer time horizon. While this may be true in general, there are many other considerations that come into play. Just because you are 65 doesn't mean you should shift your investment portfolio to conservative investments. Growing life expectancies and advancing medical science mean that today's 65-year-old investor may still have a time horizon of more than 20 years.

So, how does an individual investor determine his or her risk tolerance? Let's take a look.

How Much Are You Willing to Lose?

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, or discretionary income, is money that you can afford to lose if your investment doesn't work out. Investors with a higher net worth can afford to take on more risk than those with limited risk capital.

If you are in the lower net worth category, try to avoid being lured into riskier investments with the potential for quick and easy profits - you could lose everything.

What Are Your Investment Goals?

Your investment objectives will also determine how much risk you should assume. How much risk do you want to assume when saving for a child's college education or your retirement? For some, trading higher risk investments in an IRA can be fine - provided that you aren't risking your entire nest egg on one stock.

Don't Do Something Just Because You Can

If you are applying your entire IRA to high-risk futures in order to shelter the high potential gains from tax exposure, you may be taking on too much risk. Futures already receive favorable capital gains treatment, and capital gains rates are lower than for regular income. 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?

How Much Experience Do You Have?

Your level of investing experience must also be considered. If you are new to investing and trading, higher risk investment strategies should be limited until you have more experience under your belt. Even if you have the guidance of an advisor, it's important to understand exactly what you're putting your money into as well as all the risks involved. (To learn more, read Determining Risk And The Risk Pyramid.)

Education Vs. Financial Sophistication

When your advisor asks you what your level of investing knowledge is, what will you choose? If you're a recent business grad you may choose the "medium" or "high" option. This seems to make sense, but a business grad's knowledge is likely based more on theory than on actual experience. Similarly, an investor no formal financial education but who spend hours watching CNBC and poring over financial papers may know more than an advisor about day-to-day developments.

Spread Your Risk Around

Regardless of your risk tolerance, it's wise to always remember the old cliché and strive for preservation of capital. If you can take a big risk and still live to fight another day if a worst-case scenario unfolds, it might make sense to plunge ahead. Spreading your risk around, even if all your investments are high risk, decreases your overall exposure to any single investment or trade. With appropriate diversification, the probability of total loss is greatly reduced. (To learn more, see A Guide To Portfolio Construction.)

Careful Consideration

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 - will protect you from complete financial ruin. (For related reading, see The Seasons Of An Investor's Life and Portfolio Management For The Under-30 Crowd.)
Related Articles
  1. Wealth Management

    Buying a House Before Selling Your Own: Risks and Considerations

    Learn more about the financial risks and worst case scenarios associated with buying a home before selling your current residence.
  2. Charts & Patterns

    How To Use Volume To Improve Your Trading

    The basic guidelines to analyzing volume may not apply in all situations, but overall, they can help direct entry and exit decisions.
  3. Investing Basics

    How To Invest In Penny Stocks

    Penny stocks are highly speculative and very risky for many reasons, including their lack of liquidity and small market capitalization.
  4. Stock Analysis

    Tribune Media: An Activist Investment Analysis (TRCO)

    Learn more about the breakup of Tribune Company, once a powerful newspaper and broadcasting giant, and the role of activist investor Cliff Robbins.
  5. Mutual Funds & ETFs

    The ABCs of Mutual Fund Classes

    There are three main mutual fund classes, and each charges fees in a different way.
  6. Investing Basics

    5 Common Mistakes Young Investors Make

    Missteps are common whenever you’re learning something new. But in investing, missteps can have serious financial consequences.
  7. Trading Strategies

    4 Common Active Trading Strategies

    Active trading entails buying and selling securities with the intent of profiting from short-term price movements.
  8. Stock Analysis

    Air Products and Chemicals: An Activist Investment Analysis (APD)

    Learn about the productive, and uncommonly friendly, activist investment made by Bill Ackman into Air Products and Chemicals.
  9. Mutual Funds & ETFs

    The 4 Best American Funds for Growth Investors in 2016

    Discover four excellent growth funds from American Funds, one of the country's premier mutual fund families with a history of consistent returns.
  10. Products and Investments

    A Guide to DIY Portfolio Management

    These are some of the pillars needed to build a DIY portfolio.
Hot Definitions
  1. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  2. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  3. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  4. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  5. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
Trading Center