Some people love roller coasters. They scream and laugh through the drops and twists, and before the ride even stops, they’re ready to go again. Others hate the whole experience. If they get on the ride at all, they close their eyes, grit their teeth, and white-knuckle it to the end.
Investing is a lot like riding a roller coaster. Some love the thrill of taking big risks with the possibility of getting even bigger rewards. Others get anxious and even a little bit nauseous with every market dip and downturn.
Knowing yourself and your “risk tolerance” is an essential part of investing. Of course, you want a diversified portfolio that is built for your goals in mind, but the products and strategies you use should fall within guidelines that make you feel comfortable—emotionally and financially—when things get rough.
Otherwise, you might be doomed to make knee-jerk decisions—selling at a loss or altogether abandoning your plan to save—and that could cost you even more.
You can test your knowledge of risk tolerance with our quiz:
What is Risk Tolerance?
Put simply, it’s the amount of risk an investor is willing to take. But to determine your personal risk tolerance, it’s important to look at it at three different factors.
First is your risk capacity, or the ability to handle risk financially. How much can you afford to lose without it affecting your security? Unlike your emotional attitude about risk, which might not change as long as you live, your risk capacity can vary based on your age, your personal financial goals and your timeline for reaching those goals.
• If you’re young and have plenty of time to recover from say, a big market loss, you may decide it’s okay to be a little aggressive with your asset allocation.
• On the other hand, if you’re older and close to collecting your last paycheck, you might be more inclined to protect the assets that soon will become part of your retirement income.
• But if you have serious financial obligations (a mortgage, your own business, a wedding to pay for, or kids who will have college tuition), you may not be in a position to comfortably ride out a bear market with risky investments.
• If you have other assets (such as a home or inheritance) or another source of income (such as rental properties or a pension) you might be able to take on more risk, because you have something else to fall back on. If not, you may choose to go with safer investments in order to better protect your portfolio.
• You may want to diversify and divide your investments into buckets—with some safer assets, some intermediate-term assets and some for long-term growth—all based on your goals and timeline.
The next thing to look at is your need. When you’re determining your risk tolerance, it’s important to understand your goals and how much your investments will have to earn to get you where you want to be.
For example, if you have $100 million dollars, you likely don’t need to take huge risks, but on the other hand it may be a good idea to do so because of opportunity costs. Some may argue that you could actually take more risk simply because you don’t need to.
Additionally, it can be important to take an appropriate amount of risk to meet your goals in your investment strategy. Of course, you don’t want to take on more risk than you should, but you could potentially be losing out if you don’t take on any.
Yep, we’ve saved the best for last: emotional risk. Your feelings about the ups and downs of the market are probably the most important factor to look at in risk tolerance. This isn’t about what you can afford financially—it’s about your disposition and how you make choices between certainty and chance when it comes to your money.
We all know the saying, “Buy low, sell high .” But emotions aren’t necessarily rational. The first time your investments take a hit (and they will, it’s inevitable), fear might make you a little crazy. You may lose sleep or be tempted to sell low and put all your money in a nice, safe savings account or CD.
On the flip side, when the market is great, you may get a case of the greedies and decide to buy high or move your safe investments to something much more aggressive. Whether it’s FOMO, fear or greed or something else, emotions can cause you to make serious mistakes that can blow up your plan and forestall or destroy your objectives. A volatile market is a risk for investors, but so is abandoning a plan that aligns with your goals.
And here’s the hard part: It’s difficult to know how you’ll feel about a change in the market—especially a loss—until it happens. Note: your attitude toward risk when it comes to things like roller coasters, parachuting, and bungee-jumping doesn’t necessarily apply to how you’ll deal with financial market volatility.
The financial industry tends to use labels like conservative, moderate, or aggressive to describe risk in the context of investments and investors. The problem is, those terms are subjective. What they mean to you may be different from what they mean to someone who’s helping you put together your portfolio.
You’re probably going to want to drill down a bit. It’s also wise to think of a potential loss in terms of dollars and not percentages . A 15% loss might not sound so bad, but if you think of it as having $10,000 one month and $8,500 the next, that’s a little more daunting.
Types of Risk Tolerance
To help, here are investment risk tolerance definitions to guide you.
• Aggressive risk tolerance: People with aggressive risk tolerance tend to keep their focus on maximizing returns, believing that getting the largest long-term return is more important than limiting short-term market fluctuations. If you follow this philosophy, then you will likely have periods of significant investment successes that are, at some point, followed by big losses. In other words, you’ll ride the full rollercoaster of market volatility.
• Moderate risk tolerance: This person balances potential risk with potential reward, wanting to reduce the former as much as possible while enhancing the latter. This investor is often okay with short-term losses of principal if the long-term results are good.
• Conservative risk tolerance: Although this person is usually willing to accept a relatively small amount of risk, he or she truly focuses on preserving principal. Overall, the goal is minimizing risk and principal loss, with the person agreeable to receiving lower returns in exchange.
Investing Goals and Risk Tolerance
You may quickly recognize yourself in one of those definitions, and that’s good. It’s also important, though, to be clear about your investing goals and then make sure that the two mesh because different investment goals require different risk tolerances.
For example, if you’ll be investing your funds for 20 to 30 years, then you can ride out more ups and downs than someone who, say, will only be investing funds for five years. In the latter case, you’d likely need to be more conservative in your risk tolerance. For more information about this subject, we recommend reviewing the section about risk capacity provided earlier in this post.
Overall, it’s important to:
Recognize that all investments come with some degree of risk, some greater than others
Be clear about your investment goals
Obtain a good understanding of the degree of risk tolerance required to help meet those goals
It’s Your Decision
Have you ever noticed how the audience at a game show always screams for the contestant to go for it—to take the deal, even though he or she could lose everything? It’s not their win or loss, because it’s not their money. Your portfolio mix has to be something you and you alone (or you and your family) can live with.
That doesn’t mean you can’t get help, however. There are all kinds of financial professionals out there who are willing to assist you. Unfortunately, most of them come at a price—usually a flat fee, a commission, or a percentage of your portfolio.
The cost can be off-putting, especially for someone who is just starting out. That’s why SoFi Invest® gives members the opportunity to work with a financial planner at no charge. All SoFi financial advisors are credentialed and hold the Series 65 or another qualifying examination or designation.
They’re held to a fiduciary standard and are required to act in their clients’ best interests. SoFi’s automated investing platform invests in exchange traded funds (ETFs), which offer an easy, low-cost way to get into a diversified portfolio, via its automated investing platform.
If you aren’t sure how much risk you should take with your hard-earned savings, a SoFi advisor can help you face your fears, figure out your objectives and invest accordingly. And you can get in touch with an advisor any time you have a question or concern.
So if the market drops and your anxiety creeps up, you can talk to a professional about what to do next to keep your money secure and your plans for the future on course.
It’s SoFi’s way of making the ride a little more enjoyable with a goal of making things a lot less scary. SoFi advisors can help you build an investment account portfolio that suits your risk tolerance. Learn more and schedule a chat with a SoFi advisor today.
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