5 Steps to Determining Your Risk Tolerance

There’s a degree of risk in any financial investment. There are no sure winners and no sure losers. How comfortable you are with the latter statement may give you a clue as to your risk tolerance. You can think of risk tolerance not only as how much you are willing to lose on your investments but rather how much uncertainty you can live with from day to day.

Are you the type to sit and watch the stock ticker pass by all day? If so, does it fill you with dread or excitement? These are the kinds of questions you should be asking yourself. The answers will, in turn, help you pick out an investment portfolio that’s right for you.

1. Define Your Risk Number

Risk tolerance often varies with age, income and financial goals. Risk tolerance is a psychological characteristic which is best determined by way of a risk tolerance assessment. Some of your risk tolerance can be measured, meaning that the amount of risk you can tolerate is based on factors like your age, your income and financial goals. However, you may simply dislike making risky investments. That’s okay. You should be comfortable with spending (or not) your money the way you like.

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2. What are Your Financial Goals?

Risk is a measure of the extent to which an investment strategy can withstand negative events without seriously jeopardizing the achievement of your important financial goals. Do you save money to accumulate wealth or are you looking for ways to retire early? If your only goal is to have a nice pile of money to retire on when you’re 70, slow and steady is your investment pace. If you want to go out while you’re relatively young, you’re looking for investments that are a high risk/reward ratio. You don’t mind some volatility if it can get you to the finish line faster.

These retirement-focused goals aren’t the only goals that can impact your investment strategy. You may be saving for a house or considering buying a business. Keeping your goals in mind will impact the path to achieving these goals.

3. How Much Time Do You Need?

Along with risk tolerance, your time frame should be a major deciding factor in what and how much you decide to invest in. There is no getting around the fact that the market does not deliver rewarding returns without periodically punishing us with realized risks. It’s vital to avoid taking on more risk than you need in pursuit of your personal goals. If you have a goal you need to meet quickly (buying a home, car, wedding or college expense) or you are nearing retirement age, you may want to think more conservatively so that you don’t lose too much money from a sudden market downturn . And for those who are too conservative with decades left until retirement, you could easily be leaving money on the table. As you age, it’s important to remember how your time frame should impact your investment decisions. For example, the higher the percentage of stocks you invest in, the more volatile your portfolio is going to be. In general, you’ll want to dial down the risk and focus on more steady sources of income as you get closer and closer to your spending goal or retirement. Just as you yourself evolve throughout your career and into retirement, your investment decisions should as well.

4. Your Wealth and Income

If you have $5 million to invest, you can take more chances than you could if you have $500,000. That’s fairly straightforward. You may also consider additional factors, such as the amount of debt you’re carrying, or whether your personal ecosystem (job, family, assets, etc.) is strong and stable.

5. Get Good Advice

Working with a financial advisor can reveal clues about your risk tolerance and map out a strategy. You can prepare yourself for the discussion by looking at one of the many online questionnaires that can help you look at yourself. You can ask some of the more obvious questions yourself, such as, what would you do if presented with $250,000 to invest, or whether you like to participate in extreme sports.

Even after you’ve asked yourself the tough questions, you may still want to talk about risk tolerance and assessment with an experienced financial advisor. You may find that you are not as risk averse or risk tolerant as you thought.