When you hear “risk” related to your finances, how does it make you feel? Do you see an opportunity for great returns? Do you imagine the “thrill” of investing? Do you become worried that you’ll be left with nothing? Do you believe that risk is just an essential part of the investing process?
To better understand your risk tolerance, ask yourself questions like these and think about your behavioural tendencies, such as what actions you’d likely take after experiencing a significant investment loss or what decisions you’ve made in the past when the markets took a turn for the worse.
Providing an honest answer to these types of questions and then taking on a commensurate level of investment risk could help you build a portfolio that you’ll stick with, even when market activity makes you nervous.
What is risk tolerance?
Risk tolerance is the level of risk an investor is willing to take. But being able to accurately gauge your appetite for risk can be tricky. Risk can mean opportunity, excitement or a shot at big gains mindset. But risk is also about tolerating the potential for losses, the ability to withstand market swings and the inability to predict what’s ahead.
In fact, behavioural scientists say “loss aversion” essentially, that the fear of loss can play a bigger role in decision-making than the anticipation of gains. Since risk tolerance is determined by your comfort level with uncertainty, you may not become aware of your appetite for risk until faced with a potential loss.
Risk tolerance vs. risk capacity
Though similar in name, your risk capacity and risk tolerance are generally independent of each other.
Your risk capacity, or how much investment risk you are able to take on, is determined by your individual financial situation. Unlike risk tolerance, which might not change over the course of your life, risk capacity is more flexible and changes depending on your personal and financial goals—and your timeline for achieving them.
If you have a mortgage, your own business, children getting prepared for university or elderly parents who depend on you financially, you may be less likely to comfortably ride out a bear market than if you’re single and not holding any major financial obligations.
A financial shock like a job loss, an accident that comes with expensive medical bills or even a windfall can also affect your investment decisions by altering the amount of risk you’re able to afford.
Keeping in line with your goals
When determining your risk tolerance, it’s also important to understand your goals so you don’t make a costly mistake. Your time horizon, or when you plan to withdraw the money you’ve invested, can greatly influence your approach to risk.
Your time horizon depends on what you’re saving for, when you expect to begin withdrawing the money and how long you need that money to last. Goals like saving for your children’s university fees or future retirement have longer time horizons than saving for a holiday or a deposit on a house.
In general, the longer your time horizon, the more risk you can assume because you have more time to recover from a loss. As you near your goal, you may want to reduce your risk and focus more on preserving what you have rather than risking major losses at the worst possible time.
Translating risk tolerance into an investment strategy
Once you know where you fall on the risk spectrum, the next step is to become familiar with typical performance data for your portfolio. The more you know about what you can expect, the smaller the chance that you will react emotionally when times get tough.
Smart investors consider both risk and return. Investments with higher expected returns (and higher volatility), like stocks, tend to be riskier than a more conservative portfolio that is made up of less volatile investments, like bonds and cash. However, even the most conservative portfolio can experience short-term losses due to ever-changing market conditions. This is why it’s important to have a diversified portfolio that includes a wide variety of investment options.
The closer you get to when you want to access your money, the more those potential setbacks can sting. By contrast, when you accurately gauge your limits for investment risk, and then invest in a portfolio that reflects your risk tolerance, time horizon and personal circumstances, you’re one step closer to achieving your financial goals.
The value of investments, and any income from them, can fall and you may get back less than you invested. Tax treatment depends on the individual circumstances of each client and may be subject to change in the future. Neither simulated nor actual past performance are reliable indicators of future performance. Information is provided only as an example and is not a recommendation to pursue a particular strategy.