Do you know what your risk tolerance is?
Risk tolerance is your willingness to assume risk for a potential reward. It’s often the basis for how you invest and spend your money.
Some people throw their money into every fad, opportunity and hot new investment they come across. They have a high tolerance for risk.
Other people hoard their money in savings accounts and never touch it. They have a low tolerance for risk.
As with most things, the sweet spot for risk tolerance falls somewhere in between these two. But there are many factors at play that determine where your risk tolerance is, and it’s important that you’re aware of them.
What Makes Up Your Risk Tolerance?
How did you feel this year when the fears of the coronavirus hit and the markets dropped? Did you respond by buying more stocks, staying put or selling?
Big market drops, and how you respond, can tell a lot about you as an investor.
Risk tolerance is not how much risk you can handle. Your capacity for risk is how capable your portfolio is at handling market losses. For example, if you have a lot of money and live well within your means, you can probably handle the economy hitting a rough patch.
But your actual tolerance is your emotional capacity for risk, and your investing behaviors.
Your portfolio needs to reflect your tolerance. For example, if you invest completely in stocks but you’re not fully comfortable assuming that risk, you would probably start selling during a downturn. As we’ve seen from the past, that means you miss out on potential gains from those stocks.
If you had more of a mix of stocks and bonds, then you might feel comfortable assuming some of the risk of a downturn and stick around to see the rewards.
People are often emotional investors. If you are extremely sensitive to the changes in the market, you need to keep that in mind when you’re building a portfolio. The more honest you can be about your comfort level in investing, the more likely you are to build a portfolio that serves you well.
How to Use Your Risk Tolerance for Good
Building a well-rounded portfolio takes a multifaceted approach. You might have a high risk tolerance, but your portfolio doesn’t need to be very aggressive to help you reach your financial goals.
Risk tolerance is only one component of overall investment needs.
We also need to consider your goals, life stage and individual situation to determine what’s best for you.
A good financial advisor will know how to assess all of these factors and help you create an investment plan.
But you can also do some work to find out where you stand. First, fill out a risk tolerance questionnaire to get a general idea of where you fall.
Then, write out some rules you have for yourself and when you need to rebalance. For example, you could decide to rebalance every year or whenever your equities skew more than 5% from where you started. The rules could be anything, but the point is to have some guidelines in place for when you start to feel emotionally motivated to make changes to your portfolio.
Knowing more about your behaviors will make you a better investor overall, so it’s well worth it to learn about yourself and your tendencies.
If you need help building a portfolio that supports your goals, I can help. Contact me here to set up a call.