5 Steps to Determining Your Risk Tolerance
There is a degree of risk in any financial investment. There are no sure winners and no sure losers, either. 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 is right for you.
1. A Personality Test
The individual identity component of a risk tolerance assessment should not be ignored. Some of your risk tolerance can be measured, meaning that the amount of risk you can tolerate is based on factors like your age or your income. However, you may simply dislike making risky investments. That’s okay. You should be comfortable with investing your money the way you like. While you need to accept the tradeoff in the risk and return spectrum, which is the more risk you take the higher returns you usually can expect over a long-term time horizon. If you can’t stomach the roller-coaster like ride of investing more aggressively, you may be more comfortable opting for a lower risk, and return, investment with a smoother pattern of returns.
2. What are Your 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 are 70, slow and steady is your investment pace. In this case you are looking to have a steady accumulation over time that will be just enough for a happy retirement. If instead you want to retire while you’re relatively young, you’re looking for investments that are a higher 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. In most cases it is usually prudent to segment these various goals with dedicated savings for each.
3. How Much Time Do You Need?
If you’re relatively young, you have plenty of time to ride out the peaks and valleys of the economy and markets. You can tolerate a little more risk by design. If you have a goal you need to meet quickly (buying a home) or you are nearing retirement age, you may want to think more conservatively so that you don’t lose too much money and derail your plans. A shorter-term goal in general would require a more conservative portfolio, while a longer-term goal can be more aggressive as you have many years to overcome any losses that may occur in the short-term.
4. Your Wealth and Income
If you have $5 million to invest, you can take more chances than you could if you have $50,000. 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 that can move you towards your goals in a way most comfortable to you. You can prepare for the discussion by looking at one of the many online questionnaires that can help you look at how comfortable you are in taking risks. You can also ask yourself some of the more obvious questions, such as, what would you do if presented with $25,000 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 take an assessment with an experienced financial advisor. You may find that you are not as risk averse or risk tolerant as you thought. In doing so you can learn about yourself and make better decisions regarding your financial future.
Jeff Spitzmiller is the CEO of Ohana Wealth & Life Planning based in Cincinnati, OH. Ohana specializes in life and financial planning along with ESG (Environmental, Social, Governance) investing principles. The firm is an independent financial advisor and a fee-only fiduciary. Jeff and the firm also enjoy volunteering and giving back to the local community. You can reach Jeff at email@example.com.
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