Understanding Your Personal Investment Risk Tolerance

Risk tolerance is a crucial aspect of investing that deals with an investor's comfort level with uncertainty and potential losses. It is influenced by factors such as financial situation, goals, time horizon, and behavioural tendencies. Determining one's risk tolerance is essential for shaping an investment strategy and deciding which investments to make. It involves assessing how much market volatility and loss one is willing to accept. While it is a personal evaluation, understanding risk tolerance helps individuals make informed investment decisions and build a portfolio aligned with their financial goals and comfort level.

Investment goals: What are you investing for?

Investment goals are deeply personal and depend on a variety of factors, such as age, income, and outlook. When determining your investment goals, it's important to consider the following:

Age

Age can be divided into three distinct segments when it comes to investment goals: young and starting out, middle-aged and family-building, and old and self-directed. The investment goals of individuals in each of these age groups will differ, and it's important to tailor your investment strategy accordingly. For example, younger investors may be more focused on building an emergency fund and managing short-term debt, while older investors may be more concerned with retirement planning and generating income.

Income

Income is the natural starting point for investment goals because you can't invest what you don't have. Your income will determine how much you can afford to invest and how aggressive you can be with your investment strategy. It's important to consider your financial obligations and goals when determining how much of your income you can allocate towards investments.

Time Horizon

Your time horizon, or the amount of time you have to invest, will also impact your investment goals. Generally, the longer your time horizon, the more risk you can take on, as you have more time to recover from potential losses. If you're investing for the long term, such as for retirement, you may be able to invest in more volatile assets. On the other hand, if you're investing for a short-term goal, such as a down payment on a house, you may need to take a more conservative approach to ensure you don't lose money.

Risk Tolerance

Your risk tolerance, or how much risk you're comfortable taking on, is an important factor in determining your investment goals. Different investments carry different levels of risk, and it's important to understand your own tolerance for risk before investing. Ask yourself how comfortable you are with the potential for losses and market volatility. Your risk tolerance will help guide the types of investments you make and the level of diversification you seek.

Specific Goals

Finally, it's important to consider your specific investment goals. Are you investing for retirement, to save for a child's education, or to purchase a home? Each of these goals will have different costs and time horizons, which will impact your investment strategy. It's important to be clear about your goals and what you hope to achieve through investing.

In conclusion, determining your investment goals is a crucial step in building a successful investment portfolio. By considering factors such as age, income, time horizon, risk tolerance, and specific goals, you can develop an investment plan that aligns with your financial objectives and comfort level. Remember, investing involves risk, and it's important to understand your own risk tolerance and financial situation before making any investment decisions.

Time horizon: When do you plan on using the money?

Time horizon is a crucial factor in determining your investment risk tolerance. It refers to the period of time you expect to hold onto your investments before needing to use the money. This could be for a variety of goals, such as saving for a down payment on a house, your child's education, or your retirement.

The length of your time horizon will influence your risk appetite and the types of investments you choose. Generally, a longer time horizon translates to a higher risk tolerance. This is because you have more time to recover from potential downturns and market volatility. Historical data shows that the stock market has averaged around 8.5% returns per year, so the longer you stay invested, the more likely you are to benefit from these long-term gains. Therefore, if you're saving for retirement, which is typically a long-term goal, you can afford to take on more risk in your portfolio.

On the other hand, a shorter time horizon means you have less time to recoup losses, so you might opt for more conservative investments. For instance, if you're saving for a down payment on a house in the next two years, you would not want a sudden market downturn to derail your plans. In this case, you might choose less risky investments such as money market funds, savings accounts, or short-term bonds, which can be easily liquidated if needed.

It's important to note that your time horizon can change over your lifetime, depending on your goals and financial circumstances. For example, if you're a young investor saving for retirement, you might have a long time horizon and be comfortable with a riskier portfolio. However, as you get closer to retirement, you might adjust your portfolio to reduce risk and preserve your savings.

Additionally, your time horizon can vary depending on the specific goal you're saving for. For instance, saving for a vacation or a wedding might be a short-term goal, while saving for your child's education could be a medium-term or long-term goal.

In summary, understanding your time horizon is essential for determining your investment risk tolerance. It helps you assess how much risk you can take and guides your investment choices. By aligning your investments with your time horizon, you can make more informed decisions and increase your chances of achieving your financial goals.

Comfort with short-term loss: Can you absorb a loss in the short term?

When considering investing, it's important to determine your risk tolerance by asking yourself: "Can I absorb a loss in the short term?". This is a crucial question as it will directly inform your investment strategy.

Firstly, it's important to understand what a short-term loss is. In the context of investing, a short-term loss refers to the decline in value of an asset that you've held for a year or less. This loss is only realised when you sell the asset for less than you bought it for.

Now, how comfortable are you with the idea of a short-term loss? If you need your money in the near term, you may be forced to sell at a loss. If you have a longer time frame, you can hold on to the investment, hoping that it will recover and potentially increase in value over time.

Those with a lower risk tolerance may choose to invest in a diverse portfolio of stocks, bonds, and real assets. This way, if one asset class performs poorly, it doesn't derail their entire portfolio.

It's also important to have some savings set aside in liquid accounts. This ensures that if an emergency arises, such as a job loss or accident, you can access cash without liquidating your investment accounts.

So, when considering your comfort with short-term losses, take into account your investment goals, time horizon, and overall financial situation. Be honest with yourself about your behavioural tendencies and remember that your ability to take risks will shift over time as your goals and circumstances change.

Non-invested savings: Do you have savings set aside in liquid accounts?

Non-invested savings are an important aspect of your overall financial strategy and can provide a safety net in case of emergencies. These are funds that you set aside in liquid accounts, which can be easily converted to cash without losing value. This includes cash in checking and savings accounts, money market accounts, and short-term certificates of deposit. Having non-invested savings ensures that you have immediate access to funds when unexpected expenses arise, such as medical bills or car repairs. It is generally recommended to have enough savings to cover at least 3–6 months' worth of living expenses.

The amount of non-invested savings you should maintain depends on your risk tolerance and financial goals. If you are nervous about investing and prefer to keep a large portion of your savings in cash, it may indicate that you are risk-averse. In this case, you might consider keeping a more substantial amount in liquid accounts. On the other hand, if you are comfortable taking on more risk, you might opt to invest a larger portion of your savings. However, it is important to remember that even the most conservative investment portfolios can experience short-term losses due to changing market conditions.

Liquid assets, such as cash, provide flexibility and security. They can be quickly converted to cash without a significant loss in value, making them ideal for covering unexpected costs. In addition to cash, other examples of liquid assets include checking and savings accounts, money market accounts, and certain investments like stocks, bonds, and mutual funds, which can usually be cashed out within a few business days.

Non-liquid assets, on the other hand, are more challenging to convert into cash and may result in a loss of value. Examples include real estate, vehicles, jewellery, and retirement funds. While these assets can appreciate over time, they are not suitable for covering immediate financial needs. Therefore, it is essential to strike a balance between liquid and non-liquid assets in your financial plan.

In conclusion, non-invested savings in liquid accounts are crucial for financial stability and peace of mind. They ensure that you have the necessary funds to manage emergencies or unexpected expenses. The amount you allocate to non-invested savings depends on your risk tolerance and financial goals. By understanding the difference between liquid and non-liquid assets, you can make informed decisions about your savings and investments to meet your short-term and long-term financial objectives.

Tracking investments: Will you be tracking investments daily, weekly, or semi-regularly?

Tracking your investments is an important part of understanding your risk tolerance and shaping your investment strategy. Some people prefer to track their investments daily, while others may opt for a weekly or semi-regular approach. So, how often should you check in on your investments?

If you're an active investor who likes to keep a close eye on your portfolio, daily tracking might be the best option for you. This approach allows you to monitor your investments' performance and make timely decisions if needed. However, it's important to remember that the stock market is volatile, and short-term fluctuations are common. As such, daily tracking may not be suitable for those who are easily anxious or nervous about their investments.

Weekly tracking offers a balance between staying informed and avoiding the potential stress of daily fluctuations. By checking in on your investments once a week, you can identify broader trends and make more strategic decisions without getting caught up in the day-to-day noise. This approach can be especially beneficial for those with a long-term investment horizon, as it allows you to focus on the bigger picture.

Semi-regular tracking, on the other hand, may suit those with a more passive investment style or those who are less concerned with short-term fluctuations. This approach typically involves checking in on investments every month or even every quarter. While this may result in a more significant time lag between decisions, it can help investors avoid making impulsive choices based on short-term market movements. Semi-regular tracking can be useful for those with a higher risk tolerance and a long-term investment horizon.

Ultimately, the frequency of tracking your investments depends on your personal preferences, risk tolerance, and investment goals. It's important to find a balance between staying informed and maintaining your peace of mind. Additionally, it's worth considering the time horizon for your investments. If you're investing for the long term, frequent tracking may not be as crucial as your investments will have more time to recover from any potential downturns.

By asking yourself these questions and reflecting on your investment behaviour, you can determine the right tracking frequency for your needs. Remember, there is no one-size-fits-all approach to investment tracking, and it's essential to tailor your strategy to your unique circumstances.

Frequently asked questions