When it comes to investing, a person’s risk tolerance is an important factor in determining how their portfolio should be allocated.
I use a questionnaire to help me understand a person’s tolerance for risk. I use this information, along with other criteria, to recommend investments and the overall makeup of a portfolio.
What is risk tolerance?
Risk tolerance is an investment term that refers to your ability to endure market volatility. All investments come with some level of risk, and if you’re planning to invest your money, it’s important to be aware of how much volatility you can endure.
When gauging your tolerance for risk, consider the following factors:
Personality: Are you able to sleep at night knowing that you’ve put a portion of your hard-earned dollars at risk in a particular investment? Remember, it might be easy to tolerate a high-risk investment while it is generating double-digit returns, but consider whether you’ll feel the same way if the market takes a downward turn with your investment leading the way. It’s best to invest at a level of volatility that you are comfortable with.
Time horizon: The sooner you may need to use your investment dollars, the lower your risk tolerance. For example, for money you plan to use to make a down payment on a house in 2 years, your risk tolerance is lower than if you’re investing for retirement in 20 years. If you can keep your money invested for a long period of time, you may be able to ride out any downturns in the market (though time alone is no guarantee of higher returns).
Capacity for risk: How much can you afford to lose? Your capacity for risk depends on your financial position (i.e., your assets, income and expenses). In general, the more resources or assets you have to fall back on, the higher your risk tolerance.
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Opinions expressed above are the personal opinions of the author and meant for generic illustration purposes only. This information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investments mentioned may not be suitable for all investors. The material is general in nature. Past performance may not be indicative of future results.