A crucial factor in successful investing is understanding risk and how much you can afford to take
Whether you’re buying a government bond or shares in a start-up company, any investment you make involves some degree of risk. In general, the more risk you take, the higher the potential return.
What is your risk tolerance?
Risk tolerance is highly personal and can vary significantly between individuals with otherwise similar financial profiles. To begin to get a sense of your risk tolerance, ask yourself how nervous you get when you think about losing money, and how you would react if the value of your investments started to drop.
There are two potential dangers here:
- You’re too comfortable with risk and end up taking on more than you can really afford
- You’re so afraid of risk that you aren’t willing to take the risks necessary to get the return you need
There are also objective considerations that factor into understanding your risk tolerance:
- What is your time horizon?
If you’re saving to buy a new home in the next three years, you’ll probably want to keep your savings in fairly conservative investments so the money will be available when you’re ready. If you’re saving to retire in 30 years, you may want to consider taking on more risk. You’ll potentially get a better return, and you’ll also have time to recover from any market drops. If retirement is only a few years away, you should probably cut down on your risk so you won’t have reduced savings just as you’re ready to start withdrawing income. - How much can you afford to invest?
If you’re earning a good income and don’t have high living expenses, it could make sense to put some of your savings into higher-risk investments. But if the money you’re putting into savings is difficult to spare, then perhaps you should stick to lower-risk options.
Should you ignore your feelings about risk?
There are times when you may have to take on more risk than you’d like:
- When the market drops, our instinct may be to sell out as fast as possible. But this could be the worst choice, since the historical evidence suggests that markets recover. By selling you would be locking in your losses.
- You may feel more comfortable sticking with very low-risk investments. But it’s important to understand the possible consequences of doing so. When the time comes to spend the money you’ve saved, you may have to settle for less than you want because your savings haven’t earned enough of a return. In addition, inflation may have eaten away the value of your savings.
Balancing act
Risk tolerance is a balancing act between your emotions and your practical concerns. Often, compromise and a better understanding of how your investments work can help you achieve your goals while still sleeping at night.
A financial advisor can help you understand risk, how it applies to your situation and what type of risks are appropriate for you. In fact, if you choose to work with an advisor, one of the first things he or she will do is discuss your risk tolerance.
For definitions of technical terms in this piece, please visit iaclarington.com/glossary and speak with your investment advisor.
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