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June 17, 2020

What is Risk Tolerance in Investing?

Put simply, risk tolerance is the greatest value one is willing to lose or forgo in pursuance of some (generally, higher) return. It is a bottom line conclusion reached based upon the individuals’ own financial state and related factors of how much they are willing to put that current financial state at risk.

With this level identified—either narrow or broad ranges of possible wealth management—opportunities will exist. The higher the tolerance of the individual is generally, the more he or she will steer towards more higher risk opportunities and vice versa.

You may ask, where do I fit within this risk tolerance scale?

Conceptually, if you were to draw out a straight line on a piece of paper, this spectrum represents where you are and where you want to go. The left point is representative of you today—wherever you are in your life, career status etc.—while the right end point represents what you want to ultimately achieve.

We all have some vision on where we want to end up. We’ll call this point your “desired future.” The space between the two points represents all the actions and decisions you are ever going to make. 

Depending on what your end goal is and where you feel safe—that line can start to look pretty thin—almost non-forgiving.

How you imagine this line looks can be a relative gauge of your own tolerance to risk.

Why is this so important to consider, you might ask? Well, let’s take a step back.

Basis of risk tolerance

Humans are naturally risk-averse.

Instinctively, we prefer the feelings of safety and the comforts and the privilege of knowing what is to come next.

With regards to the areas of wealth management and investing, this basic instinct is prevalent and can keep us from making poor financial decisions.

Some Determinants of Risk Tolerance

Individual Financial Status

Having your financial house in order is just one factor that plays an impact on risk tolerance.

Just as with our basic survival instincts, we harbor and value financial security and want to do everything in our power to protect our financial well-being.

A financially strained individual who is living paycheck to paycheck while being highly leveraged will likely be willing to tolerate little to no risk when it comes to their finances.

This, of course, will generally not be the person who is seeking those “high-risk, high-reward” returns. Well, common sense says they shouldn’t be.

There is a generally accepted right and wrong way to manage personal finances, and not living beyond one’s means is a basic tenet of prudent financial management.

Education

Numerous studies have concluded there is a significant correlation between higher levels of education and greater tolerance of financial risk.

A study from 2012 reported that the number of respondents who classified themselves as moderate to highly risk tolerant were predominantly individuals who held bachelor to post-graduate level degrees.

Educated decision making should be a priority in approaching any sort of wealth management activity. Importance must be placed upon research and how to accurately weigh out all available options on a risk-reward basis. Accurate knowledge of any potential risk must be first gained before one can really determine how tolerable they are to such risks.

Time Frame

Age-based risk tolerance assessment is a significant factor in how individuals approach their wealth management decisions. The younger you are, the more you can afford (at least from a time standpoint) to pursue the heavier risk options. And the older the individual, the less time is available to financially recuperate the potential resulting loss on any higher-risk investments.

Wealth management aside, the 20-something individual has the opportunity to make that money back through working while the retiree is oftentimes not capable of returning to the workforce.

Risk – Adjusted Goals

Never let the topic of risk overshadow your own financial goals—whether they are short-term or long-term. In addition to keeping us humble, avoidance to risk can just as well hurt us in the form of opportunity cost, especially for younger individuals.

We want to put money away and invest it safely for when the time comes to buy all the things in life we would like to buy. However, investing these funds through things such as treasury securities and high-grade municipal bonds are not always the best route, especially if you have some time on your side.

Your risk tolerance should change and adapt just as you grow and adapt. As you advance in your career, gain knowledge, and get older, your risk tolerance will evolve alongside you. Once certain goals are nearing completion, the risk tolerance which was once set out for those results should be re-adjusted accordingly.

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