Understanding risk tolerance

There are a number of factors long-term investors contend with, such as inflation and longevity risk – at this time 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.

The danger of taking on too little risk

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 accumulate 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.

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. On the other hand, someone just a few years from retirement will usually take a more conservative approach.

New investors are more likely to proceed with caution, as they learn to gauge markets and begin to formulate an investment strategy that meets their comfort level.

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.

Having a clear understanding of your risk tolerance will help you determine which investments are suitable– and which investments to avoid.