How to Determine Your Risk Tolerance
We share a lot of updates and insights that are sprinkled with commonly used phrases, and if we’re not careful, we can go a long time without ever actually defining those phrases. So today we’re going to look into a very frequently used term: “risk tolerance.”When it comes to investing, risk is a given. It’s a rule of the universe that high risk is associated with high reward, but this doesn’t mean that risk is completely unmanageable. Investing is not gambling - there’s research and strategy involved. So while there is a level of uncertainty that comes with investing, there’s also ways to lessen that uncertainty. Risk is not one-size-fits-all in the world of investing - you don’t have to incur a potentially devastating amount of risk to play the game. There are varying degrees of risk, and one of the most important things an investor can do is understand the risk associated with their behaviors and understand their own financial situation and goals thoroughly so that they can determine how much risk is personally appropriate for them. This is the definition of risk tolerance, but beyond what it is lies a more interesting conversation - how you determine your own tolerance for risk.
Risk Associated with Investments
The first aspect of risk tolerance to understand is the risk associated with each individual investment vehicle. There are blue-chip stocks, and there are futures and options, and there is an entire spectrum in between. Certain investing practices have “risk reputations,” but again, the reality of risk comes down to a variety of factors. General Risk is “systemic,” meaning it applies to an entire class of investments and the market as a whole. This includes market risk, which describes volatility that is the result of political, economic, environmental, and sociological events - such as a change in business climate (ahem, the 2020 lockdowns), for example, which can cause stock prices to fall across the board. “Specific Risk” on the other hand, refers to risk that is unique to an investment or industry and includes business risk and financial risk. There are different qualities of a business enterprise that affect its value as an investment, such as leadership and product development, which are specific to the company and its operations. Financial risk is also specific to a company but refers to the mix of debt and equity a business possesses against its profits. The higher the debt of a company, the higher the risk associated with that investment. The fluctuation of the general level of interest rates, which we’ve discussed before, also contributes to investment risk. Interest rate risk affects the bonds market directly, but it can also affect other investment vehicles because increased interest rates can affect consumer and business spending.
The Specifics of Your Situation
Understanding the different risks associated with various investment vehicles is one part of the equation, but the other part of the equation is directly related to the investor’s financial situation and goals. Your capacity for risk is going to vary based on a number of factors and based on what you hope for or need from your investments. One of the first things to consider is your timeline. When do you need your returns? If you are thinking in the long-term, then you’ll be able to invest more aggressively, but if you have a shorter timeline, then conservative investments are typically wiser. Your risk capital also affects your capacity for risk. This fancy term is associated with your net worth, or your assets minus your liabilities (debt, etc.). Risk capital is the amount of money you could invest or trade without your lifestyle being dramatically affected. High net worth individuals often have more risk capital and therefore can assume more risk. Your timeline and risk capital aren’t necessarily going to stay static - they can change with your age and life events, such as having kids or switching careers. Another aspect of your risk capacity pertains to your investment goals. Your goals are in a reflexive relationship with your risk capital and timeline - meaning all of them affect each other. If your investment goals are to live off of your returns in retirement, for example, this contributes to a different risk tolerance than someone who hopes to make a large purchase in the immediate future and therefore has less “risk capital” so that they can prioritize this large purchase. It all comes down to the lifestyle you want to afford, and understanding how your investments can help and not hinder progression to manifest that reality. Your personality also comes into play with investment decisions. The amount of risk you’re willing to assume is correlated with the returns you’d be able to achieve, so if your philosophy and personality is such that you can tolerate taking larger chances, that will play into these decisions as well. Finally, an important thing to consider is your investment experience. We’ve discussed this in previous posts about types of investment vehicles, but it bears repeating that the newer someone is to investing, the more cautious they might be while they are cresting the top of that learning curve. If someone is entering a type of venture for the first time, it's a good idea to follow the rule of preservation of capital, which means that the primary goal is preserving that initial capital investment and preventing loss in a portfolio.
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The best investment options for you lies at the intersection of investment risk, personal risk tolerance and capacity, and the strategy that you apply to your investments. In each investment decision, consider these factors and determine whether you have a high or low risk tolerance. Neither is good or bad - it’s just important to understand your personal position before making investment decisions. Assessing your risk tolerance requires awareness and regular check-ins as your financial situation evolves over time alongside your changing goals, phase of life, market events, risk capital, and other factors. If the idea of assessing your own risk tolerance feels overwhelming, we understand. NEST Financial has helped many Austin - based families and individuals assess their financial situation and choose the right portfolio according to their goals and risk tolerance. We would love to help you do the same. Check out our past performance here, and reach out at info@nestfinancial.net once you see what we can do for your investments. Find us on:LinkedIn Facebook Yelp TwitterDISCLAIMER: We are legally obligated to remind you that the information and opinions shared in this article are for educational purposes only and are not financial planning or investment advice. For guidance about your unique goals, drop us a line at info@nestfinancial.net.