Our natural preference in life is for certainty. Yet we manage to live with uncertainty every day. For example, even the most sophisticated meteorological forecasts have little accuracy more than a few days ahead. But we can still say with confidence that one location has a better climate than another.
If you’ve ever been involved in any type of personal or professional growth counseling, you are probably familiar with the phrase “stepping outside your comfort zone.” This is when you are encouraged to take a risk and try something that might seem challenging either emotionally or professionally.
Risk and investing go hand -in- hand. You can’t avoid risk if you want the potential rewards of investing. Every individual has his own threshold levels beyond which he cannot take any more risks. Any responsible and reputed stock broker or finance planner will help you in realizing this threshold level unless he has already been able to assess it with his professional expertise.
An investor’s risk tolerance varies according to age, income requirements, financial goals, etc. An often seen cliche is the risk tolerance that is “age-based”. It is conventional wisdom that a younger investor has a long-term time horizon in terms of the need for investments and can take more risks compared to an old investor. For example, a 70 year-old retired investor will generally have a lower risk tolerance than a 30 year-old executive, who generally has a longer time frame to make up for any losses she may incur on her portfolio.
Identifying one’s risk tolerance depends on a few things. The first thing you will have to recognize is the amount you have invested, where you have invested and what are your financial goals?
Now how can you find out what is your financial risk tolerance. This is represented by how your finances can handle different risks.
Investing is about putting your money to work to achieve your personal goals. Setting goals forces you to plan, and having a clear goal – ideally written down – helps motivate you to stick to your plan. So when you start planning your savings for a holiday, for a home deposit, or pay for a child’s education, you actually start thinking of ways that can help you achieve your financial targets, don’t you!
Setting a time frame for each goal helps you stay on track. Allocating a time frame to each investment goal will enable you to think about how much you can afford to invest and how long it will realistically take you to reach that goal.
An investor’s ability to handle risks may be related to certain characteristics, such as age, liquidity needs, portfolio size, and income. Another factor dealing with the investor’s tendency to take risks is the amount of assets they hold. An additional factor in determining risk tolerance is the number of years to retirement. The farther from retirement you are, the more likely you will be to take higher risks, as over time the risk associated with long-term investments decreases as the market continues to increase.
After you have started investing, you might acquire the fear of encountering losses as well. And if this fear causes you to worry a lot and results into you pulling out of your investment, then a high risk investment is not for you. After steep declines in market values, you concede these investments are not comfortable owning such an aggressive portfolio, and they sell investments at a loss in order to make their portfolio more conservative.
If, on the other hand, a drop in the market causes you to start looking for bargain buys, then you are probably very comfortable with the market fluctuations. You will be comfortable with a higher level of risk. Therefore, it becomes vital to know your risk tolerance when you are actually dealing with investments.
For one to better assess risk tolerance, it would be beneficial to understand some of the different sources of risk. One source of risk is called business risk. If you are to invest in a small start – up corporation because of the potentially higher returns that are offered, you are leaving yourself open to the fact that the company may fail, rendering your investment worthless. This type of risk is not commonly associated with more established blue-chip stocks, as their likelihood of failure is much smaller. Another type of risk is market risk. Market risk is always a concern as a stock’s price may be affected by broad market trends. What does this mean? A typically strong stock may decline in value simply because the market has entered a down cycle. The best way to combat market risk is through diversification, a process by which the investor holds different types of assets, as markets do not all move in the same direction at the same time.
A further source of risk may be political. Government at all levels have a tremendous impact on the investment climate, and their attitude on business or capital sets the stage for either success or failure of the economy. A government may impose a political action, such as raising taxes to declaring war, which may harm the economic climate.
Now that you are able to determine your risk tolerance, you can assess what type of investor you are:
- Very conservative Investor
- Conservative Investor
- Moderate Investor
- Aggressive Investor
- Very Aggressive Investor
Risk is a manageable part of investing. It can work for you if you know your limits and stick to a plan that is within your tolerance for risk – taking.
So, now that you know how to assess your tolerance for risk and some different investing strategies, what are you waiting for? The longer you go without investing, the longer you will go without the benefits.