The Ancient Greeks understood that one of the most important steps in development is to “know thyself.” While we often think of understanding ourselves in terms of self-reflection as we choose a career or a life partner, this is also good advice when it comes to investing. As you create an investing plan, you should understand your risk tolerance, which is a measure of what you can handle, financially and emotionally.
What is Risk Tolerance?
Your risk tolerance is the amount of variability you can handle in your investment returns. “Properly evaluating risk tolerance is essential for creating an effective investment plan that comfortably accounts for your goals,” says Carl Aschenbrenner, a portfolio manager at Miracle Mile Advisors.
There are two main types of risk tolerance when it comes to evaluating your investment portfolio:
- Financial risk tolerance deals with the actual numbers in your situation. “Time horizon, how much money someone has, how much money will be needed at future dates, and tolerance for volatility in the portfolio are all important factors to consider,” says Aschenbrenner.
- Emotional risk tolerance is more about how much you can stomach. Even if you have a high financial risk tolerance, with enough money to invest for the long term, you might feel uncomfortable, emotionally, with a lot of volatility, and that can affect the way you handle your portfolio.
Understanding how your risk tolerance impacts your portfolio is a big part of creating a successful investing plan.
The Impact of Risk Tolerance on Your Portfolio
“Once risk tolerance is determined, an asset allocation can be implemented to deliver the desired or required return with minimal risk,” says Aschenbrenner. Likewise, it’s also possible to use this information to implement strategies that offer the most potential return for a certain level of risk tolerance.
Your financial risk tolerance largely influences how much you can set aside for the future, and whether or not your portfolio has time to recover from mistakes and downturns in the market. If you have a long time horizon, and a steady job that allows you to invest in your company’s retirement plan, you have a reasonably high risk tolerance. You have enough money to build your portfolio, and the time horizon in which to do it.
If you are close to retirement, and worried about losing value in your portfolio in a downturn just when you start to drawdown, your financial risk tolerance is a little different. You can see how your investment strategies might be different, depending on how much money you have available, and what you plan to use the money for — and when you need access to that money.
Don’t forget about your emotional risk tolerance, however. Sometimes, your emotional risk tolerance can cause problems with your portfolio, no matter your financial risk tolerance. If you have a high emotional risk tolerance, you might get a thrill out of frequent trading, and chasing returns. However, if this high emotional risk tolerance isn’t tempered with a different approach, you could lose more money through your choices. If your financial risk tolerance isn’t high enough to support your high emotional risk tolerance, it can be devastating to your financial future.
Low emotional risk tolerance can also be problematic, since it can lead investors to sell in a panic at the first sign of trouble, locking in losses, even though they have sufficient financial risk tolerance to ride out the problem. The key to balancing these issues, says Aschenbrenner, is to consider working with a system or a professional who can help you devise a plan that has reasonable return potential, by that reduces the emotion involved. “Clients who have experience investing or working with an advisor have often learned to set their emotions aside,” he says. “Newer investors can really benefit from an experienced, professional advisor who can help them make decisions with less emotion.”