There are a number of factors long-term investors contend with, such as inflation and longevity risk – for this article, we are going to focus on market risk, and specifically risk tolerance.
Your risk tolerance – the degree of risk you’re willing to accept when investing – is a critical factor in building a successful investment plan. While some investors are able to handle large swings in the value of their investments, others may become nervous every time the markets dip.
Determining your risk tolerance is critical because if you take on too much risk, you might panic during a market downturn and sell at the wrong time. For instance, what would you do if your portfolio went down 25% in a year? Would you be tempted to sell immediately, wait a few months and re-evaluate, or do nothing? While someone with a low risk tolerance might be tempted to sell right away in order to limit their losses, an investor with a high risk tolerance would probably hold steady–or even look to buy investments trading at a bargain.
While every investor needs to be cautious with their investment decisions, it’s worth mentioning that there’s also a risk in being too cautious. For instance, if you don’t take on enough risk, you might not make enough money over the long term to meet your investment goals. Risk-averse investors often forget that there are solutions to mitigate risk. It’s all about knowing what your risk tolerance is, embracing the power of long-term thinking and seeking out consistency in your investment portfolio.
5 levels of risk tolerance
When it comes to assessing risk tolerance at Scotiabank, we use five main categories: low, low/medium, medium, medium/high and high. Let’s take a closer look.
Those with low risk tolerance are often more focused on preserving capital and generating income, as opposed to driving strong market returns. Risk-averse investors generally have a diminished tolerance for volatility, particularly if they are close to reaching their investment goals.
Investors with low/medium risk tolerance prefer investments with below-average volatility yet can accept some moderate volatility over the medium-to-long term. In the event of a typical market downturn, an account may decline by as much as 10% over a one-year period (or by substantially more in the event of a more severe market correction).
Those with medium risk tolerance can accept investments with average volatility, which will fluctuate in value by a substantial amount over the medium-to-long term. In the event of a typical market downturn, an account may decline temporarily by as much as 15% over a one-year period (or by substantially more in the event of a more severe market correction).
Investors with medium/high risk tolerance can accept investments with higher volatility, which will fluctuate in value by a substantial amount over the long term. In the event of a typical market downturn, an account may decline temporarily by as much as 20% over a one-year period (or by substantially more in the event of a more severe market correction).
Those with a high risk tolerance can accept high volatility and significant fluctuations in the value of their investments over the long term. In the event of a typical market downturn, an account may decline temporarily by as much as 30% over a one-year period (or by substantially more in the event of a more severe market correction).
3 key factors affecting your appetite for risk
1. Time horizon
The period from now to when you will need to access a significant portion of the money in your account(s) refers to time horizon. If you have a longer time horizon to invest, you may choose to be more aggressive with your investments. Conversely, someone just a few years from retirement will usually take a more conservative approach.
2. Investment experience
New investors are more likely to proceed with caution, as they learn to gauge markets and begin to formulate an investment strategy that doesn’t keep them up at night.
3. Your investment objectives
Your investment objectives must also be considered when calculating how much risk can be assumed. For example, those saving for retirement may be less willing to take on higher levels of risk, as opposed to someone taking part in a more speculative investment strategy.
What works for you?
Having a clear understanding of your risk tolerance will help you determine which investments are suitable– and which investments to avoid.
Legal Disclaimer: This article is provided for information purposes only. It is not to be relied upon as investment advice or guarantees about the future, nor should it be considered a recommendation to buy or sell. Information contained in this article, including information relating to interest rates, market conditions, tax rules, and other investment factors are subject to change without notice and The Bank of Nova Scotia is not responsible to update this information. All third party sources are believed to be accurate and reliable as of the date of publication and The Bank of Nova Scotia does not guarantee its accuracy or reliability. Readers should consult their own professional advisor for specific investment and/or tax advice tailored to their needs to ensure that individual circumstances are considered properly and action is taken based on the latest available information.