Discovering one’s investment risk tolerance can be quite challenging for some people. How can you quantify what often feels like a subjective, emotional response to risk? The following info is not exhaustive by any means, but I think this post will provide a great start in determining what your risk exposure should be. From here, you can better evaluate if your portfolio is suitable.
A person’s risk tolerance incorporates a lot of variables, but answering the following questions will help you to identify your basic investment risk profile:
- What is your NEED for risk? Or, how much risk do you need to take to achieve your financial objectives? A simple financial plan can help you determine if you need to achieve a high rate of return or not. Note that this question is not what your preference for risk is. Some people may be surprised to see that with some prudence, they can aim for a low return and still meet their financial objectives. Others will not have this luxury.
- What is your CAPACITY for risk? Or, how much risk can you afford to take? Once again, through a review of your financial situation, you should be able to determine how much financial margin you have to work with. Will any portfolio losses devastate your financial goals? Or can you financially handle some losses since you have the ability to make up any differences, if necessary?
- What is your emotional TOLERANCE to risk? Or, what kind of risk can you handle and how bad does it need to be before you’ll start losing sleep at night? Remember, risk can be defined in many ways. While volatility is one type of risk that can cause stress, not being able to access your funds for long periods of time (liquidity risk), can also cause anxiety for some.
One last comment on risk tolerance: in my opinion, a person's emotional risk tolerance can really be best identified in periods of turmoil because this is when it is tested. If I see a client who is calm and collected during a high-risk situation when negative events begin unfolding, then I know they have accurately identified their risk tolerance as high. But a lot of people believe they have a high risk tolerance, but then they get extremely upset, stressed and obsessive about their investments when things begin to go offside. In these latter cases, I know that while they long for those high risk returns, their inherent risk tolerance cannot handle the drama.
Maria Dawes, Portfolio Manager
Capstone Private Wealth