How To Measure Your Risk Tolerance
Understanding your risk appetite is the first step before deciding the best route to achieve your financial goals. What is risk tolerance? It is a measure that tells how much an investor is ready to withstand in attaining the financial target. Measuring risk tolerance is an integral part of investing. You can understand how much you are prepared to stomach when the market takes large swings. If you don’t know your tolerance capacity, you may panic and sell the wrong stocks at the wrong time.
Financial planners will often ask you about your risk appetite to suggest suitable investments according to your risk profile.
Defining Risk Tolerance
In simple terms, it defines how much risk you are ready to withstand when your portfolio is performing poorly. When you are investing in stocks, there are chances that market trend reverses from an uptrend to a downtrend, this is where your risk tolerance comes into the picture. It is an estimation of how much loss you can stomach. If your outlook regarding risk is conservative, you will choose low-risk investment options. Understanding risk tolerance helps you decide the game plan.
Factors in Risk Tolerance
No two investors indeed have the same risk tolerance level, but some common factors will give your financial advisor an idea about your risk capacity, such as,
Goals: Your financial goals tell the advisor how much money you expect from the investments to achieve your financial target. Before you even begin a financial journey, you need a clear understanding of how much wealth you want to build and accordingly build the investment game plan.
Timeline: Your risk appetite is directly linked to the period you want to stay invested. Generally, the longer you stay invested, your risk-taking abilities increase along with the chances to optimize profit. The stock market will produce a positive return over time but to encash on it, you must stay invested and ride the bumps. Usually, an investor at 30 has a greater risk appetite compared to an investor in 50s.
Net worth and disposable income: Your risk-taking abilities decline with age. But for high net-worth individuals with more disposable income, risk tolerance may remain unaffected even with advanced age.
Portfolio size: Your portfolio size determines if you can take higher risk. Usually, with a larger portfolio, you have more cushion when the price drops. It also means you can explore more investment options when you have more money.
Personal preference: Some investors, by choice, are aggressive risk-takers, so they prefer investing in high-risk equities. When a financial advisor plans an investment journey for you, he takes your risk profile into account.
Deciding Risk Tolerance
Advisors use questionnaires and surveys to decodes your risk abilities. Besides, as an investor, you may also want to evaluate the worst historical return on investment to understand the maximum amount you can lose in different asset classes in case your investment performs poorly. Future earning capacity and time horizon also factor in risk evaluation. Usually, when you have financial stability or income-generating assets, your risk tolerance increases.
Based on risk appetite, investors are divided into categories such as conservative, moderate, and aggressive.
Experts warn investors against the risks of ignoring risk tolerance while investing. Investing without considering risk factors is like walking on an acrobat’s rope. It may happen that when the price drops, you panic and sell even when the swing is well within your risk tolerance capacity, committing the biggest mistake as an investor, that is selling low.
Another common mistake that investors make is misinterpreting their real risk appetite. Some investors claim themselves as aggressive risk-takers when, in reality, they prefer moderate exposure, means they would sell the stocks when the price declines and flee the market. Rightly gauging your true risk tolerance will let you calibrate your investment accordingly.