Knowing your risk tolerance can make the difference between a smart investor and a sorry investor.
Understanding your risk tolerance is essential in developing a successful retirement strategy. The overarching principle of risk is that the higher it is, the greater your potential for growth, but also the greater your potential for loss. Risk tolerance isn’t a static consideration. As your investments change over time, so should your tolerance for risk, especially as you near retirement.
Typically, the closer you are to retirement, the lower your risk tolerance will become. The younger you are, the more time you have to make up for short-term losses. However, if you’ve still got some ground to make up before or in retirement, you may need to accept additional risk for the opportunity to reach your financial goals.
Continue reading to learn more about risk tolerance, its importance and how to determine yours.
What is Risk Tolerance?
Essentially, risk tolerance is the degree of volatility in investment returns an investor is willing to withstand over time. In other words, it’s how much you can stand to lose in the short term. How much risk an investor can tolerate varies widely and is determined by a number of different factors. It can be influenced by the news, friends, family, your gut and emotional connections to particular investments and money in general. The most considerable influence on risk tolerance for your retirement accounts show be driven by two factors, time to retirement and retirement goal. Once you’re in retirement, your risk tolerance again changes. Generally, retirees have a much lower risk tolerance, and would look for conservative investments.
Levels of Risk Tolerance
- High risk tolerance
With high investment risk tolerance, you are a natural risk taker and an optimist. You like weighting your portfolio with lesser-proven stocks or other investments that have the opportunity for big gains, but could also dip dramatically if certain assumptions about markets and demand don’t pan out.
- Moderate risk tolerance
If you can tolerate some risk, you probably prefer investments that are likely to produce solid gains over time but also have the potential to drop somewhat.
- Low risk tolerance
If you’re uncomfortable with anything but small risk, you’re most likely to only invest in conservative assets. You only feel comfortable with the type of investments that typically generate more moderate gains in share prices but are less likely to dip.
How to Determine Your Risk Tolerance
When assessing how much investment risk you can take on, thinking practically is important. Your financial circumstances may justify some reasonable chances or may merit more conservative choices. If you’re not sure what your level of risk tolerance is, start by asking yourself the following questions.
What Are Your Investment Goals?
Why are you investing? Everyone has their own reasons for investing but some common goals include:
- Buying a home
- Paying for your children’s education
- Financial independence
Determining the why of investing is the first step in understanding how much risk you’re willing to take on. Additionally, having a goal in mind helps assess your time horizon and estimate how much money you’ll need.
What’s Your Time Horizon?
Your time horizon is the amount of time until you plan to use the money you’ve invested.
Generally, the larger your time horizon, the more risk you can take on. If your investments lose value, you have more time for them to recover. While downturns occur and past performance is no guarantee of future results, the stock market has historically bounces back, offering long-term returns.
A shorter time horizon means your investments have less time to recover from a potential downturn. If your goal is to earn a big return in a short period of time, larger risk is necessary. The closer you are to retirement, or if you’re already there, your time horizon would be short.
Do You Have an Emergency Fund?
Regardless of your risk tolerance, it’s important to have savings set aside in liquid accounts. If you face an emergency, you want to have easy access to cash without having to liquidate investments. However, if you keep a large portion of your savings in cash because investing makes you nervous, this is a sign you’re risk averse.
Keeping a specific amount in cash to help ride out market fluctuations is extremely important, so always make sure your emergency fund is topped up.
How Comfortable are You Taking Short-Term Losses?
It’s common for investments to fluctuate in the short term. With stocks and similar investments, it’s important to remember that your shares may decline in value, but you don’t realize the loss until you sell the investment. If you’re in need of the money in the near-term, you may be forced to sell at a loss. Investors with a longer time frame have the ability to hold onto the investment with the hopes of recovering and potential increases in value with time.
Every investment comes with risk, but it’s important to understand the balance of risk and reward that is best for you and is appropriate for your portfolio. Generally, as you near retirement or enter into it, it’s much safer to add more conservative, low risk investments into your portfolio. Of course, this always just depends on personal preference and what makes sense with your own financial situation.
Risk tolerance is a highly individual matter and can be sensitive once you move into retirement. You should consider working with an experienced and trusted financial advisor who can help further shape your risk capacity and suggest products that fit within it. At Agemy, we specialize in retirement income planning, helping you take care of yourself and your loved ones. Whether you’re looking to change up your financial strategy, need assistance with wealth management or legacy planning, or just want someone with you while you jump into retirement, we’re here for you!