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This article was originally published on marcus.com.
Risk tolerance essentially comes down to how much potential loss you’re prepared to handle with an investment and for how long you can stomach that loss. We all hope for as little downside as possible when we invest. But volatility is an innate part of investing, and the (largely unpredictable) dips and climbs will impact the value of your assets.
When it comes to determining your risk tolerance, it’s important to be honest with yourself about how comfortable you are with risk. Are you okay seeing your portfolio shoot up and down with the market? Or would you rather see less volatility?
Why is risk tolerance important? In short, the point of getting to know your risk tolerance is to help you put together a portfolio that reflects both your risk preference and financial goals.
Like a lot of things in life, risk exists on a spectrum. Generally speaking, though, there are three main levels of risk: aggressive, moderate, and conservative. You can certainly fall in between two levels or closer to one extreme than the other.
If you’re an aggressive investor, you’re typically comfortable taking on bigger risks to potentially score bigger returns. But you’re also aware that bigger risk could come with bigger losses if your investment doesn’t pan out as expected. You’re usually heavily invested in stocks with a smaller percentage, if any, dedicated to safer assets like bonds. Often, younger investors fall in the “aggressive” category, since they’ll have more time for their holdings to recover from any dips in the stock market.
Moderate investors usually have a portfolio that’s a healthy mix of stocks and bonds. Bonds are usually more stable than stocks but also typically have lower returns. If your investment goal is medium term (six to 20 years), it can be a good idea to have a portfolio that’s balanced between risky and safe assets.
Finally, conservative investors like to take on little-to-no risk and therefore may be more heavily invested in less volatile assets like CDs and bonds. That doesn’t mean your portfolio should consist solely of CDs and bonds, but you’ll want the majority dedicated to these generally more stable vehicles.
Your tolerance for risk can change over time. The risk tolerance of a young person just starting out in their career would likely change by the time they reached retirement or even in 10 years. People generally become more conservative investors as they get closer to retirement, when there will be less time for the value of assets to recover if the market dips. But that might not be how you’ll feel as you near retirement. So be honest with yourself and open to changing risk preferences at different stages of life.
Now that you know about the different levels of risk tolerance, how can you figure out where you stand? Keep in mind–just about all of these factors are interconnected in one way or another.
Not sure what your comfort level is? Risk tolerance questionnaires can be found online or you might request one from your financial advisor. If Ayco is offered through your employer, speak with a coach to walk through a risk tolerance assessment and determine what type of investor you are.
Higher risk equals potentially higher returns. Which makes sense—if you’re willing to take on more risk in the hopes of bigger returns, that seems like a fair trade-off. But, the reality is rarely quite that simple.
For example, as we mentioned earlier, stocks generally have higher returns when compared to bonds. But we also know there’s volatility in the stock market. You can’t rely on past performances to guarantee future returns. Knowing your risk tolerance can help keep you realistic about your returns and help build a deeper understanding of volatility in the market.
On the other hand, if you can’t handle a lot of volatility and are more risk averse, your returns may be more predictable. But those returns may also be potentially smaller than they would be with riskier investments.
At the end of the day, your risk tolerance can guide you to the right personal investment mix. Sticking with that mix, and reassessing from time to time, is key to meeting your financial goals and having greater peace of mind.
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Updated for tax year 2020
Updated for tax year 2019