A couple of weeks ago I started a series of articles designed to help our readers with investment portfolio planning. The first article discussed setting investment goals, which help you figure out exactly what you are saving and investing for. This week we move on to determining your risk tolerance – a step that will help you identify your preferences for investment risk.
What is Risk Tolerance?
There is generally a direct relationship between investment risk and investment return. To clarify, risk can be defined as the probability that your investments will not perform as expected. In other words, it’s a measure of how likely you are to lose money. Return is a measure of how much your investments increase in value.
Typically, the more return you want from your portfolio, the more risk you will have to take on to get it. Money in an FDIC-insured savings account is subject to very little risk – it’s virtually impossible to lose it. But at the same time, the return on it is very small. You will likely need a greater return if you are to meet your investment goals. This will prompt you to put money in riskier investments (such as stocks).
Risk tolerance is an approximate measure of how much investment risk you are willing to take on. While everyone wants as much return on their investments as possible, not everybody should go for the riskier investments. You need to find a balance between risk and return that is appropriate for your situation (the so-called efficient frontier in the Modern Portfolio Theory).
Determining Your Risk Tolerance
The first, and most important, part of determining your risk tolerance is identifying your investment time horizon – the amount of time you have until you need to withdraw money from your portfolio. The longer you can keep your money invested, the greater your risk tolerance, since you can weather the ups and down of riskier investments. On the contrary, the less time you have, the lower your risk tolerance – you don’t want to lose money shortly before you need it.
Look at your investment goals and calculate how long you have until their deadlines. Then use the following guidelines to get a gauge for your risk tolerance:
- Low Risk Tolerance – Time Horizon < 5 Years
- Medium Risk Tolerance – Time Horizon 5 to 15 Years
- High Risk Tolerance – Time Horizon 15 + Years
The second part of getting a feel for your risk tolerance is asking yourself – “How comfortable am I with loosing a lot of money in a short period of time?”. Some of you may be risk takers and watching your investment portfolio swing up and down doesn’t make you blink. Others may be more conservative and unable to stomach large declines in portfolio value.
Be honest with yourself and make a note of your preference:
- Low Risk Tolerance – I am fairly conservative and would like my portfolio to be stable
- Medium Risk Tolerance – I am willing to take risks, but I don’t want to lose too much money in a short period of time
- High Risk Tolerance – I am a risk taker and market ups and down don’t scare me!
Putting It All Together
Now you should have two levels of risk tolerance to work with – one based on your time horizon and the other on your personal preference. They should help you come up with an overall risk tolerance for your portfolio. Your time horizon should hold much more weight when making your decision. Your personal preference shouldn’t be the deciding factor.
Don’t worry if this process doesn’t seem very exact. It’s designed to give you an idea about your risk tolerance and help you when picking your asset allocation later in the portfolio planning process. If you need additional help, try taking some online risk tolerance quizzes (like this one from Bankrate and this one from Wells Fargo). Just don’t take their results as absolute truths.
That’s it for this installment of our Portfolio Planing Basics series. The next part discusses how to choose an appropriate asset allocation for your portfolio. And if you missed the previous article or want to look ahead, the entire series is as follows:
- Setting Investment Goals
- Determining Your Risk Tolerance
- Picking an Asset Allocation
- Choosing Investments
- Opening Appropriate Investment Accounts
- Buying Investments
What methods have you found to work the best when determining your risk tolerance?