Investing, no matter what you do, will involve risks. There is no way for you to avoid encountering any risks while making decisions about your future or current investments. You must know the level of risk tolerance that you have to help guide you in making the right investments for you.
Let’s first breakdown the meaning behind the term “risk tolerance” in order to understand it better.
What is “Risk Tolerance”?
This is an investing term that relate to the amount you can tolerate as an investor in terms of market risk and volatility.
The financial dictionary defines it as:
“The extent to wish an investor is willing to accept more risk in exchange for the possibility of a higher return.”
Your tolerance is usually measured through a calculator, or more often, a questionnaire. If necessary, there are instances in the history that you can review detailing worst-case returns for different asset classes. This can help you determine the amount of money you would actually be comfortable parting with. Only if your investments end up in a worst-case scenario.
A positive way of looking at risk is to see it as an opportunity. It can also be a cause for excitement or provide you a shot at big gains. But another way to look at it as a way to tolerate the possibility of incurring losses. It also tests your ability to withstand market swings and how you will react with the inability of predicting the future.
This is a different aspect of risk tolerance. Risk capacity refers to the amount of risk you can actually afford to take. It is different from the amount of risk that you can willingly take.
Also, your risk tolerance has the possibility to stay the same for the course of your whole life. On the other hand, your risk capacity points to how much investment risk you are actually able to take on.
This is decided by your own financial situation. Risk capacity is more malleable and can change based on your financial and personal goals.
Things to Consider When Taking Risks
1. Assess your current financial condition
Ask yourself first, where do I currently stand in term of my financial situation? How much money do you currently earn? Are you in a position wherein you’ll be able to take risks without endangering everything you have financially?
Basically you need to answer how much you can actually sacrifice without giving up any of your previous consumption pattern or standard of living. Through self-analysis, you will have a better understanding of where you are and where you want to be financially.
2. Achieving your goal
It is well-known that in order for you to be successful in investing, you must have a clear goal you want to achieve. Having your own goal will help you understand and choose the best investment that you can undertake with minimal risks.
You can get help from others – professional financial advisers or people who you trust ultimately. But seeking professional insight is not a bad thing to consider. There are some investment projects that can prove to be tedious. It’s still greatly advised that you find yourself a professional adviser for the long run.
It is important to keep in mind that it’s no coincidence why wealthy investors have financial advisers.
3. A back-up investment
One thing you should avoid at all costs when it comes to investing is putting everything in one investment. Do not tie up all your liquidity in a long-term investment that will not allow you to redeem without penalty.
There is a saying in the investing world, “Do not put all your eggs in one basket.” But if you only have one, you should find the safest basket you can put it into. Try your best to diversify. Find different investment projects you can partake in, with different market conditions.
Balance your portfolio to minimize the risk, and therefore your losses.
Also keep in mind that in time of an emergency, you might need to get your hands on cash right away.
There are positive and negative emergencies that can take place. Negative emergencies that can happen are sickness and death, these are important even though it can mean losing money. Positive emergencies can come in the form of invest projects that can generate profits immediately.
Always be ready to place your investment in case of emergency, no matter what form it may take.
Read up on Tips for High and Low Risk Investment.
4. Understand the investment
Do not be blindfolded by the fine print of some invest projects and portfolios that you come across.
The fine print is important; it is legally binding and should not be neglected. It’s not bad to listen to your friends or family’s recommendations when it comes to the next big investments. Just make sure to not disregard due diligence. Do your research and understand the investment before making any final decisions. Know if the investment is indeed worth your time. Will it deliver real return at the end of the day? What do you stand to gain if you do decide to take up the investment? How much will you be investing and what is the annual rate of return? Will you receive the best return for your investment? It’s important to note that you will not only be investing your money but also your time and energy.
Remember that you will be the one making the investment and not them. This means that you should understand the venture as much or more than them before taking any risk in investing. Just like what we previously said, it’s really advisable to seek professional financial guidance when investing.
5. Emotional capacity
Risk tolerance not only concerns your financial ability to handle risk. It also involves your emotional ability to deal with risks.
It’s important to know if the amount of risk will stress you out too much to the point that it affects the other aspects of your life. You should also know if you’re so risk averse that you never include investments that can possibly increase your wealth.
Why Knowing Your Risk Tolerance is Important
Assessing and understanding how much risk you can actually tolerate will help you in terms of finding the right investment for you. You will be able to measure how much risk you can actually handle. It will also give you the opportunity to assess the appropriate amount of risk you should take.
There are numerous risk-related questionnaires that can help you gauge your level of tolerance. This can help you make sure that you are entering the right venture and will not be dragged down by surprises.
We’re not saying that there will no longer be surprises. Instead, knowing how much risk you can actually take will ensure that you aren’t biting off more than you can chew.