For an investor, the idea of risk is an essential part of building the right portfolio. But what is risk in investment terms? And how can you figure your own risk tolerance? Here's a short guide to this important, but often misunderstood, financial element.
What Is Investment Risk?
Risk, when it comes to investing, is the risk of financial loss. This loss could come as a complete loss, such as if you invest in a collectible that is rendered worthless for some reason. But more often, the risk is that you will lose a portion of your investment, like a stock that drops in value before you sell it.
Every investment carries a certain level of risk that ranges from small to very great. When you invest in a bond, you take the risk that the organization that issues it won't stop paying back its debt. But most bonds also have protections built into them that make this risk very low. On the other hand, your risk when investing in company stocks is greater because there are fewer protections.
What Is Risk Tolerance?
Investment risk itself is universal. It's the same for every investor. But your risk tolerance is unique to you. Tolerance is your level of comfort with the amount of risk in your portfolio. Some investors are more nervous about losses, making their tolerance for risk lower. Others can absorb greater risk without losing sleep. These individuals have a higher tolerance.
Risk tolerance can also change at different times and in different settings. The right amount of risk in one part of your portfolio might be acceptable while it's not tolerable in other areas. Or you may find that your risk levels change — both up and down — as you become more used to investing.
What Factors Affect Risk Tolerance?
So, what may alter your risk tolerance? The factors vary greatly, but some are common. One of the most important is how long you have until you will access the money. If you don't need the money for 10, 20, or 30 years, you can risk greater fluctuations in its value. But retirement investors generally reduce their risk levels as they get closer and closer to withdrawing money.
The purpose of the investment can also affect tolerance. If you depend on the money — say for college in a few years — you may not feel comfortable gambling with its value. But if the investment is less obligatory (like a vacation fund) you may feel freer to chase higher returns with higher risk.
One of the biggest risk tolerance factors is also one that's hard to quantify: your comfort level. As risk goes higher, you may reach a point where you worry about losses too much. You may literally lose sleep or feel stress symptoms. This generally means your risk is higher than your tolerance and you should consider other options.
Other factors in risk tolerance analysis may include individual versus overall portfolio levels, the manner in which you plan to withdraw money, the economy, and your general financial health.
What Is the Right Risk Tolerance?
There is no one right risk tolerance. It depends on many factors, both personal and universal. The best way to determine what's right for you is to work with an experienced investment advisor or financial planner. They will guide you in finding the right levels of risk in whatever situation you face.
Presidio Wealth Management can help. With nearly 20 years' experience assisting investors of all tolerance levels, we can help you achieve a good balance to reach your goals while ensuring you can still sleep comfortably at night. Call today to make an appointment.