Risk is inherent in investing and there is no one size fits all approach to managing and dealing with risk. What keeps you awake at night might be well within someone else’s comfort level.
The central principal of investing is the higher the risk of a particular investment, the higher the possible return. Of course the flip side of that is that low risk investments typically offer low returns. Those that are attracted to high returns need to be sure that they can cope with the volatility that can accompany those types of investments and those who want stability need to ensure that they are prepared to compromise on return for investment.
It’s worth developing an understanding of how you feel about risk as your risk tolerance should dictate your investment strategy.
What is risk tolerance?
Risk tolerance is the degree of variability you’re willing to withstand with your investments. In other words, the ups and downs you can put up with. Risk tolerance varies from person to person as well as over time. For example, someone with a very short investment time frame and a very important investment goal might not be willing to put up with peaks and crashes. They might not have time to start again if something goes wrong with a risky investment. On the other hand, someone with a longer time frame (someone at the start of their career, for example) might be willing to take that risk, for a potentially higher payout.
What shapes people’s risk tolerance?
Part of your risk tolerance is based on hard numbers. Put simply, it’s comparing your investment goal to the data available on your potential investment options. And then putting that in the context of other factors, like economic risk. It’s the other part that’s particularly interesting.
The psychology of risk tolerance draws from many different areas of behavioural psychology. Risk taking behaviour can be influenced by emotional factors; how the person is feeling at the time, or how they think they’ll feel if their decision pans out as expected. Your decisions can also be shaped by your past experiences.
It’s possible that your approach to some types of risk might be formed by an early age – when you’re in primary school.i By that age, you’ve already absorbed a lot from your parents and siblings. But that doesn’t mean you can’t understand more about where you’re coming from, and in doing so, get closer to your goals.
Balancing your risk tolerance and goals
In general, problems arise when your risk tolerance is low, and your goals are particularly ambitious. But when you have a more-than-high tolerance for risk – even a love of the thrill of chasing extraordinary returns – you may be tempted to break your medium to long term plans. Even when you’re on track to achieve your goals. In other words, balancing your risk tolerance and goals takes a consistent effort.
What is your risk tolerance?
Risk tolerance is different for everyone. ‘Know thyself’ is the adage, and a common and simple test is to think about how you’d be likely to react to a significant fall in the value of your investments.
Conservative investors are likely to want to sell and run, believing that this will mitigate their losses. Aggressive investors on the other hand might use the drop to increase their holdings. Most people are somewhere in between these two poles.
We can help you to work out your risk tolerance, and assist you to make investment choices based on your profile, situation and investment goals.
If this article has left you feeling like it’s time for a discussion – and maybe even a change – get in touch with us. We’re here to assist you in planning your investments in order to achieve your goals.
i In context of physical injury: https://www.ncbi.nlm.nih.gov/pmc/articles/PMC2610559/