Risk tolerance can be defined as ‘the degree to which various risks are important to a particular individual’.
Your risk tolerance is a vital component to your investment’s long-term performance. Your risk profile, which is determined by your tolerance for risk, can be divided into two categories:
- Financial capacity
- Emotional capacity
To bring it back to basics, think of your risk profile as a two sided-coin. Each side being equally important in assessing how much risk you can tolerate for your potential investment.
Example – What rate of return do you need to achieve your financial objectives?
Your financial capacity can broadly speaking be brought back to two variables – time (e.g. time horizon, stage in life) and amount of money (e.g. net worth, income needs, liquidity requirements). Take an investor’s time frame for investing – the shorter your time horizon, the less financial capacity for risk you have. Likewise, dependency on an investment alters an investor’s risk tolerance (is there a required return to pay off bills?). And the portion the investment represents of your overall wealth also adds or detracts to your tolerance. Given you may not have the ability to recreate capital should markets perform poorly.
Example – How well would you really cope if your investment falls by 10 per cent?
The majority of investors would answer this question rationally on any given day when completing a risk assessment. However, emotions are not rational. The first time your investment takes a hit (and this will happen at one point or another), fear often takes over and poor decisions may be made. Selling at a low point and exiting your investment strategy may not be the option to take. Understanding the level of volatility you can cope with is vital in the selection of your investment strategy. When the appropriate strategy is chosen correctly, investors are more likely to continue with their investment over the longer term and achieve their goal.
In both respects, investors can make mistakes which may result in substantial losses to their investment.
How to avoid mistakes with identifying your risk tolerance and investment strategy
- Keep emergency funds aside from your investment that cover 6 months’ living expenses. This will avoid depleting your investment to cover unexpected events
- Choosing a managed fund will help reduce your risk by diversifying your investment across numerous asset classes, geographies and sectors avoiding sole reliance on one particular company’s performance
- Reduce debt before investing to help alleviate pressure on the required investment returns
- Invest with an appropriate long-term time horizon and stick with it
An Authorised Financial Adviser can help you determine how much risk is appropriate for you and your overall financial situation by taking both your emotional and financial capacity into account. Your Financial Adviser will also review your risk tolerance on an ongoing basis. This is particularly important because an investors’ risk tolerance varies throughout their lifetime.