The Ultimate Guide to Understanding Risk Tolerance

Understanding your risk tolerance is an integral component of creating a financial plan and investing portfolio. Your risk tolerance determines the mix of assets you choose based on how easily and willingly you can withstand uncertainty.

Your risk tolerance will likely evolve over time. Life events, such as marriage, parenthood and major medical expenses can alter your appetite for risk.

Age

Age can often determine the degree of risk an investor is willing to accept with their investment portfolio. Younger investors tend to be more accepting of taking more risk in their portfolio due to having longer investment horizons; older investors on the other hand may prefer less volatile assets like bonds or bond funds as an investment vehicle.

Note, however, that age does not determine risk tolerance alone; other factors also play a part - temperament being one such influencer; some people tend to be less risk-averse than others.

How a person amasses wealth is also an influential factor, as this may sway their risk tolerance when investing. Therefore, understanding your risk tolerance and creating a well-diversified portfolio are two keys to meeting financial goals without feeling stressed out by them.

Net Worth

Net worth is an effective measure of one's overall wealth. It encapsulates their assets (cash savings, investments and the value of their home) minus any debts they owe - an indicator of overall wealth that people of all income levels can work toward increasing through wise spending habits and paying down debts.

Your current net worth provides an indication of how much risk can be undertaken without impacting your ability to pay debts or maintain lifestyle needs. Therefore, this metric should be calculated on an ongoing basis.

Investment Goals

Your financial goals play a large part in shaping your risk tolerance. For instance, an early retiree with limited savings may take a different approach to investing than someone who needs to maximize return on their savings in their last working years.

Personal comfort levels also impact investment styles. If you have a stable income source and low debt levels, taking on more risks might feel safe; but if you recently lost your job or fear losing health insurance could make investing riskier less attractive than initially planned.

Your knowledge of investing and trading is also an integral factor when assessing your risk tolerance. Are you comfortable with the concept of loss? An investment advisor can fill any knowledge gaps so you can make an informed decision regarding how much risk to take on.

Time Frame

Understanding your risk tolerance and crafting an investment portfolio that balances risk with rewards is paramount to meeting your needs and goals. Deliberating upon and allocating assets will enable you to ride out inevitable market downturns more comfortably.

Your investment time horizon also plays a critical role in your risk tolerance. For example, those saving for retirement should have more of their assets invested in stocks than if they require the funds soon for home purchase.

While it can be easier to assess your risk tolerance when the markets are rising, it's also essential that you ask yourself how you would respond during a decline. Working with a financial advisor, you can create a plan to assess and reevaluate your risk tolerance on an ongoing basis to make sure it remains aligned with your long-term investment goals.

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