How To Assess Your Investment Risk Tolerance?
Updated: May 15, 2021
One of the most important things while working on your investment portfolio is to understand your ability to tolerate risk. Risk can mean a lot of different things to different people. Some people might believe that working on a startup can be a risky career option to choose whereas there are also a lot of people who might find it more rewarding and believe having a laid-back normal lifestyle is more prone to risk.
A person's risk-taking behavior in personal life is not really a pattern that can define the risk tolerance ability in investing. In the case of investing, the risk comes down to the fact that how much can you tolerate watching your investment dropping without losing your calm?. We all know that the market is pretty volatile and can go in both directions, you might up your investment by 20 percent one day, other days it might do down by 30 percent, so the idea is not to get emotional about it easily. Therefore you need to understand your risk tolerance in order to find what kinds of investments will work for you.
Few Tips For Assessing Your Risk Tolerance
Usually, if you have a low-risk tolerance, it's better for you to allocate more of your investment to short-term investments and investment-grade bonds but if you believe you have a high tolerance for loss, you can allocate more of your investment to stocks. Here are a few tips to understand your risk tolerance capability:
Age Is An Important Factor
Age is a very important factor while evaluating your risk tolerance capability. Usually, if you are someone who is about to reach your age of retirement, you are going to have a very low-risk capacity when compared to someone who is decades away from their age of retirement. However, If someone is approaching the 60s, they can still have an investment period of 10-15 years easily. It is very important to have a rate of return on investment that can avoid your running out of the money while retirement. The main risk here is withdrawing too much from your investment portfolio in the initial years of your investment, especially when your investment value is declining during those years.
Many specialized advisers recommend to keep your withdrawal to a maximum of 4% of the starting value of your investment yearly. This margin of 4% is based on historical stock market data but with a decrease in interest rates and an increase in life expectancy in today's market, you might have to set the limit of withdrawal to 2.5% to 3 % maximum that too after paying your taxes.
Go Through Past To Understand Risk
Although past results can never determine the future effects, still going through the past is a very effective way to start and understand your risk evaluation. There is a very common saying "If it's happened before, it can happen again" which hold very true to a lot of scenario in the world. During the financial crisis of 2008-09, the market lost more than 57% of its value, but it again went up and surpassed its previous highs. So you have to think and understand, whether this kind of fluctuation is ok with you or not.
Be Ready To Expect Downtime
Historic data have repeatedly shown that no one can regularly and successfully get their way in and out of the stock market without avoiding downtimes. You might have heard various stories where people will tell you how they avoided the market downtime by planning their way in and out of the market. But all these claims are fugazi, they either got lucky or have no evidence to prove it.
It is a simple fact that for every investor who successfully times the market, there is one another investor who was unsuccessful. So the probability of being on either the losing or winning side is 50/50 nothing better than that. Historic data shows that investing in a risky opportunity eventually leads to more money in your bag rather than keeping your money in a bank account, that's the whole point of investing in stocks and other risky assets. The idea of getting high returns lies in your ability to stand through the inevitable downtimes and into the next recovery. You also need to keep in mind that downtimes can sometimes last for years, so once you made the decision to invest, make sure to stick with it for the long haul.
Take Risk Conservatively, If You Are OK With Less Growth
If your investing strategy is too conservative, there is a high chance that you will end up making much less money 25 years down the line. That's why it's important to understand your investments in terms of how it will possibly lead to your goal, which is a very important thing in financial planning. Financial planning needs not to be complex and hard to understand, there are various online services that can help you in basic calculations of your financial plans. The main advantage of having an aggressive investment strategy is that you will be able to get a high rate of return over time, thus reduces that amount you have to save now. But if the course changes due to some market correction or recession, you might get a low rate of return when compared to the conservative strategy.
Know Your Actual Risk Affordability
If you are someone with no debt, a lot of money in your account, and low expenditure, you can afford to take a bigger investment risk but this doesn't mean that you have a high tolerance for risk. You might want to live a normal life and have a normal investment goal and don't want to deal with the wild fluctuation of your money. If you are this kind of person, then you have high-risk affordability but low-risk tolerance. On the other hand, if you are someone who has an aggressive investment strategy but has less money in the bank, poor insurance or debt, but somehow still ok with your investment value going down during market downtime, then you are someone who has low-risk affordability but high-risk tolerance.
Always remember, every person has their own level of tolerance and affordability in almost every aspect of life, the same holds for investment. So the real idea is to assess yours and then delve into the world of investment rather than just doing it blindly. You will definitely make some mistakes, but that should not stop you from trying things.
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