All investors need to evaluate which investments are right for their financial situation. While this article presents things you may want to think about when determining your risk tolerance, we do not offer investment advice; it is up to each investor to speak with your financial advisor and evaluate each investment opportunity for yourself.
How do you feel about danger? Most investment decisions are driven by risk tolerance more than any other single factor — whether the investor is conscious of it or not. Analyzing your personal risk tolerance will let you take better control of your portfolio and target the right risk-reward ratio for you.
But how do you figure out your risk allowance profile? Let’s see how well you know yourself, shall we?
Your Investment Risk Tolerance
Your tolerance for risk is made up of four building blocks: General disposition, timeline, experience, and net worth.
1. General Disposition
Have you ever jumped out of a perfectly good airplane? Would you?
Adrenaline junkies dream of leaping out of airplanes and bungee jumping. To someone with anxiety, those are nightmare scenarios. Most of us fall somewhere in between the two extremes.
Your financial risk tolerance may reflect your general love of adventure — or it could be very different, depending on your relationship with money. An athlete who grew up in poverty may love whitewater rafting but be very uncomfortable with high-risk investing.
Self-test: If you invested in a stock and then watched the price drop every day for a week, would you be up all night pacing across the floor? Or would you want to buy more while the price is low?
If you’re in your 20s, you might be able to ride out some dips in the economy. You’ll learn from bad experiences and hopefully manage to make up for any losses over time.
But if you’re close to retirement — or already retired — a dip could seriously impact your income in the immediate future. You may not be able to afford to wait a few years for the market to recover if your quality of life is on the line.
That’s why an investor’s risk tolerance at 25 years old is generally much higher than the same person's risk tolerance at 60 years old.
Self-test: How many years do you have before you start withdrawing funds for your goal (retirement, home purchase, education)?
3. Investment Experience
Reading and listening to experts is a great way to learn — but book learning is no substitute for the school of hard knocks. In fact, some complex and high-risk investments are only available to “sophisticated investors,” meaning those who have extensive experience or have presumably proven their expertise by accumulating a high net worth.
Self-test: How many years of actual investment experience do you have?
4. Net Worth
Risk tolerance is also impacted by net worth. If you’re living paycheck to paycheck and you have only $1,000 to invest, losing it all would be a tragedy.
If you have a million-dollar portfolio, on the other hand, you can probably afford to gamble $1,000 on something speculative like an indoor pickle farm.
Self-test: How much can you honestly afford to lose?
Blending a Balanced Portfolio
Your investment portfolio offers an infinite range of possibilities — to match the infinite number of points on the risk tolerance spectrum.
For instance, just because you’re approaching retirement doesn’t mean you have to put all your money into government bonds. You could move most of it into safer investments and use a smaller percentage to seek high returns.
Conversely, even if you're young and willing to take risks, having a certain percentage of your portfolio invested in something stable might protect you from volatility.
Self-test: What does your ideal portfolio pie chart look like?
The Final Word
Your personality may range from pure adrenaline junkie to total scaredy-cat — but your investment risk tolerance is likely to shift as your experience, timeline, and net worth change. You can adapt your portfolio to your exact risk tolerance at any given time by allocating more or less of your money into stocks, bonds, real estate, businesses, mutual funds, crypto, and other investment vehicles.