When it comes down to your personal finances, investing is one of the recommended methods of growing your wealth to ensure that you have a stable financial future. One of the most important things you have to consider before investing is your risk tolerance.
Basically, this is the amount of losses that you are willing to take on in pursuit of greater gains. As such, it plays an important part in determining your financial goals and investment decisions.
Risk tolerance is affected by a number of factors. In order to reach your financial goals, you may have to adjust your risk tolerance over the years to accommodate shifting economic climates.
Why knowing your risk tolerance is important
Apart from its importance in personal finance and goal settings, knowing your risk tolerance helps you to optimise your investment potfolio. Taking on too much risk can lead to financial ruin, while taking too little may affect your ability to grow your wealth.
In relation to investing, risk tolerance represents a spectrum, with “risk averse” on one end, and “risk seeking” on the other. Most people tend to fall somewhere between these two extremes. Your risk tolerance will help you determine a sweet spot that will allow you to make decent progress towards your goals.
The risk averse end of the spectrum represents those who are unwilling to take any risk with their personal finances. They prefer to keep their money in safe, low-return investments like government bonds. While this can help to safeguard your finances, your returns will be very low in the long-run.
The other end of the spectrum are risk-seekers. These individuals are not afraid (or can afford) to put their finances on the line for potentially high returns. They may invest heavily in the stock market or other volatile assets, which can give them massive earning potential, but also opens them up to significant losses. While this strategy may offer high yields, it is not for everyone as the stress and anxiety associated with it can drain you both mentally and physically – and even financially.
Things to consider when assessing risk tolerance
There are a few more things you need to consider when assessing your risk tolerance in investment. These include:
Your personality type
You might be wondering “What does my personality have to do with investing?”. Surprisingly, quite a lot. Are you someone who sleeps soundly at night knowing that your investments are working as you rest? Or are you someone that needs to see immediate results to feel validated and comfortable?
Your personality type can give you some clues as to what level of risk tolerance you have. Someone who is naturally anxious and easily stressed may want to tread cautiously while investing. Thrillseekers who like living hard and fast may be more comfortable with risk taking, and thus might be more willing to gamble on riskier investment opportunities.
Your investment time horizon
An investment time horizon is the time period one expects to hold an investment and is another big factor when determining your risk tolerance. If you plan on investing for a short -term goal, such as a downpayment on a house, you might be less willing to take a huge risk as you need to see some results as quickly as possible. On the other hand, long-term goals such as retirement may lead you to willingly take on more short-term risks with the knowledge that over time, your investments have a chance to grow and recover from market downturns.
Your current age also affects your appetite for risk. Younger individuals may have less to invest, but have more time to spend to overcome market volatility. Conversely, those who are older may play it safe in order to protect their retirement funds.
Your overall financial picture
Always look at the big picture before committing to a new investment. If you have a large emergency fund and little debt, your risk tolerance may be higher as you will have a larger cushion in case you make any mistakes. On the other hand, if you do not have that much in terms of savings and plenty of debt, you may want to consider a more conservative and risk averse strategy to avoid landing yourself in even more debt.
The most important thing to remember is that you should never invest money that you are not prepared to lose, even if it’s on a relatively “safe” investment. Returns are never guaranteed and you should always be prepared to make a loss.
Why adjust risk tolerance?
Now that you know the many factors that can affect your risk tolerance, the question is why do you need to adjust it? The simple answer is that your initial assessment may have been to conservative or aggressive. Perhaps your life circumstances have changed, such as you getting married or having kids. All these factors may require you to reconsider your risk tolerance so that you can optimise your financial gains.
Additionally, your financial goals may have changed as a result of life developments. Initially, you might have just been investing to hit retirement goals. However, if you have a child, you may want to take more risks in order to grow their college education fund.
Once you have a good grasp on your risk tolerance, you can set yourself up for success. If you need help with readjusting your risk tolerance, don’t hesitate to seek help from a financial advisor, or maybe even try new investment strategies. Whatever the case may be, make sure that you do your research beforehand and are comfortable with the risks you are taking.
If you are still not comfortable with making your own investment decisions, you can try using a robo advisor. Robo advisors allow you to automate your investments based on your risk tolerance and are a decent choice for beginners and those who are not too familiar with the investment market. You can find out more at iMoney’s Learning Centre, which has a list of promising robo advisors that you can use to get started investing.
