The phrase “risk tolerance” is spoken a lot when you have a conversation with a financial planner or investment manager. Most people know that it has something vaguely to do with how much risk they’re willing to take on regarding their investments – but beyond that? Many Americans are left scratching their heads. The truth is that there are two different things that people are actually talking about when they discuss risk in your financial plan – risk tolerance and risk capacity. Both play a large role in financial decisions.
What is Risk Tolerance?
Risk tolerance is defined as the amount of risk you, as an investor, can tolerate. Risk tolerance explores the emotional side of investing. Everyone has a different level of risk that they can tolerate in their portfolios. Some people will be risk averse, meaning they don’t want any risk in their portfolio at all. Others will be risk seeking, meaning they love the thrill of a big risk and a big payoff – and the idea of a larger loss doesn’t intimidate them.
What is Risk Capacity?
Risk capacity is the technical side of risk, or the amount of risk your portfolio can (and should) take on in order to achieve your long term projected savings goals. Investors who either have a high net worth to begin with, or have less need to begin tapping their investments right away, have a higher capacity for taking on risk in their portfolio. However, some investors who need to reach a large savings goal sooner rather than later, may also be good candidates for a little bit more risk in their investment decisions. This might be a couple who hasn’t saved anything yet for retirement, or maybe a young professional who has plenty of time to stay in the market and gain return on their investment.
Balancing The Two
Although it’s tempting to only follow your risk capacity, it’s impossible to untangle your emotions from your finances. This is why knowing your risk tolerance, and acting accordingly when investing, is so important. If you’re a risk averse investor, you are more likely to react emotionally when your investments underperform for a longer length of time than expected. You may also make a rash decision if the markets experience a drop. Although most financial planners understand that the market balances itself given time, it’s challenging to remain that passive when it’s your money and your future on the line.
For this reason, it’s important to know yourself. To uncover your own risk tolerance, you can ask yourself the following question:
If the market fell 20% over the course of the next year, what would I do?
Usually, people find themselves in one of three categories:
- Do nothing, the markets will stabilize.
- Wait a period, then act if things don’t improve.
- Sell right away, this level of loss is too much.
There’s no right or wrong answer to this question. Instead, you can use your answer to determine how comfortable you are with risk when it comes to your investments, and act accordingly.
Options for the Risk Averse
While there are some risk-seekers out there, most of us fall into the more conservative, risk averse category of investors. There are some times when taking on risk in your portfolio will be necessary. These decisions are called “required risks” and every investor experiences them at some point in their journey. In these cases, you are required to take on a certain level of risk in your investments in order to achieve the long-term savings goals you’re working toward.
Being fearful of risk is normal. However, you don’t want your aversion to risk to negatively impact your ability to save for retirement, grow a nest egg, or achieve other long-term savings goals. Of course, this is often easier said than done.
If you know that you struggle with risk in any aspect of your life, and especially when it comes to your finances, you have a few options:
- Create a long-term investment strategy that minimizes risk, and stick with it.
- Contact a financial planner who can act as your sounding board.
A financial planner can help you to look at your investment decisions without emotional attachment. They can walk you through the pros and cons of each investment, and how they fit into your long-term strategy. They can also help you to organize a retirement savings plan that incorporates your workplace retirement account, such as a 401(k), and any other investment accounts you may or may not have. If you’re interested in learning more about how a financial planner can help you to balance your risk tolerance with necessary investment decisions, contact us today.