The Importance of Understanding your Risk Tolerance
As J. Kenfield Morley once said, “In investing money, the amount of interest you want should depend on whether you want to eat well or sleep well”.
Are you sleeping well at night regardless of what the market is doing? If the answer is yes then the asset allocation you have selected to reach your investment objective may be right one for you. When defining your investment strategy, one of your first tasks is to assess the amount of risk you are able to tolerate. Although higher levels of risk are associated with higher potential returns, you need to be sure you are comfortable with a higher risk exposure. An investor with a high risk tolerance will tend to have an asset allocation heavily weighted with stocks, where an investor with a lower level of risk tolerance will likely need to increase the amount of bonds/cash equivalents and reduce the stock exposure in their portfolio. Portfolios with a higher stock exposure will fluctuate more than safer portfolios which can cause inexperienced investors to make their buy and sell decisions at exactly the wrong time.
It is important to distinguish between your attitude towards risk, which is based on your personality, and your capacity for risk, which depends on your ability to generate noninvestment income.
Some things to consider when assessing your risk tolerance include:
- Are you single or married?
- Does your spouse work?
- Do you have children or plan to have them? Tuition bills coming?
- Are you self-employed?
- What could hurt your career?
- Do you invest in the stock market to supplement your salary?
- Can you cover all your expenses with your salary?
- How much can you afford losing in your investments?
Make sure your risk exposure is no greater than what you can bear. If not, you are likely to commit the mistake of selling low when the market drops significantly (which will happen several times throughout your investing lifetime). Once you determine your risk tolerance and select the appropriate asset allocation you need to stay the course over long term to have the best chance of reaching your financial goals.