There’s no such thing as a free lunch. Nowhere is this truer than in the world of investments. When it comes to investing, gaining access to higher returns comes at a price. And that price is called risk. In investments, risk is commonly defined as the possibility and magnitude of incurring a loss. But actually, risk can be more broadly defined as the possibility of obtaining something other than what you expected. So, risk can actually work in your favor. In terms of investments, you could end up with a return that is higher than what you initially expected because of the riskiness of an investment. In fact, in investments, the following relationship holds true: the higher the return, the higher the risk.
All this talk of risk may sound frightening. Does it mean that you should avoid risk? Especially when it comes to your hard-earned savings? The answer to that question is a resounding…“it depends”. The amount of risk that you are willing to take and are capable of taking is called your risk tolerance. Your risk tolerance is a function of several factors that are unique to you and is thus different from the risk tolerance of another person
Here are some factors to consider in determining your risk tolerance:
- Your return objectives. The higher the return you require in order to achieve your financial goals, the greater the amount of risk you will need to take.
- Your age. The younger you are, the greater the amount of risk you can take. Why? Simply because you have more time to recover from any losses that you incur and because you have more income-earning years ahead of you.
- Your total assets. The larger your total assets, the greater the amount of risk you can take. This is because you have more to draw from for your regular expenses should you incur losses in some of your other investments
- Your investment time horizon or the length of time you are willing to keep your money invested. The longer your time horizon, the greater the risk you can take. The reasoning behind this is similar to the reason behind age: the longer the time horizon, the more time to recover from any losses.
- Your past investment experience. This partly determines your attitude to risk. A bad experience from a past investment may make you more gun-shy and risk averse. Or, your past experiences could have helped you better understand the risk that each investment carries and could have made you more willing to take on risk.
- Your general attitude to risk. Other factors such as your personality or the people around you may influence your appetite for risk.
The first 5 factors determine your ability to take on investment risk. These are the more objective determinants of risk tolerance. The last two determine your attitude towards risk and are obviously a bit more subjective. It’s important to understand the distinction between a person’s ability to take on risk and his attitude towards it. Sometimes, there are people who objectively can take on much more investment risk than they are currently taking but simply refuse to do so because they are just not comfortable with the idea of losing money. On the other hand, there are people who are willing to take on more risk even if they literally cannot afford to do so. Neither is ideal investor behavior. It’s always good to achieve a balance.
Understanding your risk tolerance then helps you determine which investments are suitable for you.
Find out what your risk tolerance is. Take our risk profiling test