All investments carry a tradeoff between risk and return—generally, the higher the risk, the higher the potential return—or loss. Conversely, the lower the risk, the lower the potential return or loss. The goal is to find the right level of risk that provides the returns you need, while letting you get a good night’s rest.
Temperament, age, stage in life, investment experience, financial goals, and time horizons are all factors that affect one’s risk tolerance. Following is a brief discussion of some of these points to help you assess your own personal risk tolerance:
Temperament. Not everyone is comfortable taking financial risks. Just because someone is a weekend extreme rock climber doesn’t necessarily mean that this risk-taking behavior extends to his or her finances. When selecting investments, it is important to bear in mind that different types carry different degrees of risk, and also that returns for specific investment types may vary over time. For instance, stock market returns that have historically risen over the long term have experienced wide short-run fluctuations. Looking back at the historic 1973–1975 recession, the stock market dropped by 46%. Ask yourself: “How well would I have weathered that loss?”
Age and Stage in Life. Single investors may be able to carry more risk than married couples with children. Individuals just embarking on their careers and building wealth can usually take on more risk than those nearing, or already in, retirement.
Investment Experience. Sophisticated investors, who understand capital markets and are knowledgeable about specific investments, can typically assume more risk than novices.
Financial Goals and Time Horizons. Another consideration is the amount of time you have to meet your financial goals—that is, your time horizon. For example, if you begin saving for retirement early, you can generally afford to assume a higher degree of risk. While it is not wise to take on more risk than you are comfortable with, remember that the amount of risk you are willing to carry may potentially affect the level of return you can expect.
It is prudent to assess your risk tolerance before beginning an investment program. Then, reassess it periodically as you progress through life’s major stages, such as when starting a family, changing jobs, or approaching retirement. Understanding your risk tolerance can help guide your investment decisions, and help you sleep more soundly at night.