Balance your financial goals against how much risk you can handle.
When it’s connected to personal finances, the word “risk” can mean very different things to different people.
One person might consider risk the rollercoaster-like thrill of seeing how much money they make on their investments without losing too much along the way. However, another investor might see risk as a danger sign—the necessary discomfort they face whenever they invest in the stock market.
Both investors’ definitions are right. In the investment world, risk tolerance is a very personal thing. However, it’s important to understand how much risk you’re willing to take when you invest. By doing so, you’ll do a better job of picking investments that meet your financial goals, but don’t keep you awake at night with worry.
What is investment risk?
Whenever you invest money, you’re hoping that your investments will increase in value. Unfortunately, investing doesn’t offer guarantees. There’s always a chance that your investment could lose value.
Generally, risk and return are connected. The more financial risk you’re willing to take, the greater your chance of your investment appreciating. On the other hand, when you put money into very low-risk investments, your money may be safer but you may not get as much of a reward either.
What is personal risk tolerance?
Most people have a general tendency, or attitude, toward financial risk. On a 1-10 scale, a person who is a “1” has an extremely low risk tolerance. This individual is not willing to invest in anything that might lose money.
An investor who’s a “10” would be a high-risk investor. This individual hopes to earn big returns on their investments, and is willing to ride some pretty volatile ups and downs in the market to get that result.
In reality, most investors fall somewhere along the risk spectrum, not just at the extreme ends. Also, a person’s appetite for financial risk can change according to a particular financial goal or over time.
How do I determine my own risk level?
Some financial companies’ websites offer interactive risk-assessment quizzes. If you work with a Financial Advisor, they can ask detailed questions to help you determine whether you’re generally a low-, moderate- or high-risk investor.
For instance, you might be asked to answer true or false to questions like:
- “If my investments drop by 20% in value over the course of a year, it’s easy for me to resist the temptation to sell them.”
- “I want significant earnings from my investments and I’m willing to go through significant market fluctuations to hit my goal.”
- “It’s important for me to safeguard the money I’ve invested, even if my account doesn’t keep pace with inflation.”
Using risk information to become a better investor
Once you understand your risk level, you’re ready to choose your investments. Many investments are upfront about their risk ratings. You can use that information to decide whether the investment option matches your risk tolerance. A Financial Advisor can also help you pinpoint an investment’s risk level.
Defining your personal risk tolerance is one of the key attributes of a smart investor. When you match your investment portfolio to your individual circumstances and your time horizon—as well as the level of financial “chance” you are comfortable taking with your money—you’re in a strong position to achieve your financial goals.
