Understanding your Risk Tolerance

How you determine your investment choices depends greatly upon both your emotional and financial ability to take on risk

In this section, you’ll…

• Learn about risk and it’s relationship to returns
• Understand the importance of knowing your risk personality
• Determine your individual risk tolerance

It’s easy to over estimate your ability to ride out the markets ups and downs. That’s especially true when the markets are booming. Many investors find they’ve over estimated the amount of risk – or volatility – they can cope with. So when the market does go south, they sell. The result is often unnecessary and sometimes significant losses incurred.

Before you set out to make any investment, either simulated or real, you should have a feel for your risk personality – it’s a critical factor to know when building your investment portfolio.

Don’t overestimate your ability to manage risk. How you think you could handle risk and how you actually handle it are often very different from one another in reality.

What is Risk?

Risk is the financial uncertainty that the actual return on an investment will be less than the expected return. There is an undeniable rule about risk and how it relates to investments – the higher the potential returns, the greater the risk. Conversely, the lower the risk, the less the potential for returns.

Risk tolerance is the measurement of your willingness, as an investor, to suffer a decline (or repeated declines) in the value of your investments while waiting and hoping for them to increase in value.

Some people are risk tolerant – meaning they are more comfortable taking on higher amounts of risk when it comes to their investments. Others are risk averse -meaning they have a lower tolerance for taking on risky investments.

Investors who understand their risk tolerance have more comfort in their investment choices.

Rating Your Risk Tolerance

Knowing your individual risk tolerance before making any investment decisions is important as it will govern your actions and reactions when the market takes a downturn.

Some investors know their risk tolerance – others do not. Also, individual risk tolerances can change over time due to new or changing priorities like the start-up of a family or the approaching of retirement.

Interpreting Your Risk Tolerance

Perhaps you’ve discovered that you’ve got nerves of steel. Market corrections and crashes don’t raise your pulse one bit. On the other hand, you may have found you’re nowhere near able to live with as much volatility in your investments as you thought.

If you are risk-averse, don’t worry. The more you educate yourself about risk, the easier it is to handle. But regardless of your risk personality, it’s always wise to think of stocks or similar type investments as just one plank in building a profitable portfolio.

In the next lesson, we’ll introduce you to other major types of investments that well-diversified portfolios are comprised of that you should get to know and understand. They will help you build in some financial as well as psychological cushions when you set out to develop your real-life portfolio.

Today there’s an incredibly wide choice of investments – some regulated, some not. As we’ve experienced in recent times a regulated investment does not (and does not aim to) provide any measure of certainty of growth, nor security. Each type of investment has an inherent degree of risk associated with it and a corresponding potential for returns. By understanding your risk tolerance level, you’ll be able to decide which types better suit you.

The bottom line? If you don’t mind your investments hitting volatile peaks and troughs, you shouldn’t necessarily look down towards investing in more risky assets.

It is recognisesd that some individuals are better able to tolerate financial risk than others. Indeed, in some cases the higher a person’s level of wealth and income relative to their liabilities, and the longer their investment time-horizon, the more capable they are of taking a financial risk and therefore have a greater capacity for risk.

Key Learning Points

• Knowing your individual risk tolerance before making any investment decisions is important as it will govern your actions and reactions when the market takes a downturn.
• Risk is the financial uncertainty that the actual return on an investment will be less than the expected return.
• There is an undeniable rule about risk and how it relates to investments – the higher the potential returns, the greater the risk. Conversely, the lower the risk, the less the potential for returns.
• Some people are risk tolerant – meaning they are more comfortable taking on higher amounts of risk when it comes to their investments. Others are risk averse -meaning they have a lower tolerance for taking on risky investments.