Understanding Your Risk Tolerance


Understanding Your Risk Tolerance


Way too often, we always hear lovers say “I will risk everything for you. I will do anything for you.” in mushy love stories. But what does that mean, really? What does the person mean when he says “risk”? And does the person really mean “everything”?

So many questions are running through our heads right now. Let’s start getting our answers by knowing what “risk” is first. Risk is a situation with exposure to danger, harm or loss of something of value. It is the possibility that something bad or unpleasant will happen. Let’s go back to the sappy love story we were talking about. When a person says he is “willing to risk everything”, it probably means that he or she is ready to lose or compromise whatever is needed just to pursue the lover.

Why Take Investing Risk?

But why put yourself in a position of risk when you don’t have to? It’s because you want to gain returns. Risk is always present in our everyday lives. When we cook, we run the risk of getting burnt or wounded. But why do we continue cooking anyway? Because we want to have food to eat. The food is our return. When we drive, we always run the risk of getting into an accident. But why do we still drive? Because we want a fast and convenient way of getting from point A to point B. You get the picture.

Investing also entails risk, lots of it. As an investor, you need to determine how much risk you’re willing to put yourself into. But before we go to your risk tolerance, you need to understand one of the core principles of finance: The Risk-Return Tradeoff.

risk vs return

What Is Risk-Return Tradeoff?

This basically means that risk is directly proportionate to returns. Meaning that the more risk you take, the greater the probability is for a higher return. Take note that the operating term here is “probability”. It is not automatic that if you take on high risks, you are guaranteed high returns. It doesn’t work that way. It means that there is a chance for you to get high returns.

Obviously, when you invest, your expected return in profits or income from your investments. When you invest your money into, let’s say, a savings bank account, there is minimal, close to no, risk. But the returns, in this case, interest income, will also be minimal. However, if you invest your money in stocks, there is a greater risk due to the volatility of the stock market. The probability of a greater return, or profits, is also high.

Your Risk Tolerance

Before you invest, it is important to understand that there is always a chance that you will lose some or all of your money. All investments have corresponding risks, just not to the same degree. As investors, you need to assess what your risk tolerance is to guide you on where to put your hard-earned money.

How Do You Assess Your Risk Tolerance?

Here are 4 factors you should consider.

1. Your Age

They say age is just a number, but in determining your risk tolerance, this is a huge factor. Usually, when you are younger, you have a longer “time horizon” ahead for investing. A major goal for most people is to retire by a certain age (age 65 for example). If you’re 25, you have many more years until 65, in comparison to someone who’s 55. Therefore, you can take more risks because you still have plenty of chances to take corrective measures in case you fail (fingers crossed).

In contrast, when you are older, you have a shorter “time horizon”, so you would want to be as careful as possible in choosing where to invest. Therefore, your risk tolerance is gearing towards conservative investment vehicles, such as bonds and money market securities.

2. Available Capital

If you are a person with more money to spare, you tend to have more flexibility when it comes to choosing your investments. Therefore, your risk tolerance can be higher because your net worth is higher. On the other hand, if you only have your small life savings to invest, you would want to make sure that you make the most of it. Therefore, your tolerance to risk tends to be quite lower.

3. Investing Experience

Experience truly is the best teacher. Of course, when you start investing, you would not expect to be an expert on the ins and outs right away. So you will, of course, incur some learning curve along the way. When you are new to something, you tend to be more cautious in your approach. Thus, if you are an investment newbie, you’re more likely to take on less risk than a seasoned investor.

4. Investment Objectives

– Why are you investing? Do you want to buy your own house in 5 years? Do you want a new car? Do you want to save for retirement? Do you want to travel the world?

Knowing your objectives and how much these goals will cost is key to identifying your risk tolerance. Say, for example, you want to buy that fancy Cadillac by next year, and knowing the fact that these precious Caddys will cost you a fortune, you would want to invest in something that will produce more returns for you. Therefore, the corresponding risk will also be high.

Final Thoughts

There are also a lot of other reasons your risk tolerance will be high or low. But you get the main idea. So, the next time your lover tells you he or she is willing to risk it all, we all know how to respond: “Baby, is your risk tolerance unlimited?”