Some people live on the edge, some play on the edge, and some invest on the edge. No doubt today’s market teaches you fast how you feel about risk. How much financial risk can you tolerate?
Most investors ask themselves this and most financial advisors should ask it of clients. This question defies an answer of one word or a quick sentence.
Risk tolerance is simply an investor’s appetite for taking a chance that things will go wrong. Some investors’ stomachs churn when they think about losing money in the market. Another way of saying this is that these investors are risk averse or risk intolerant.
The market’s ups and downs leave other investors unconcerned and willing to accept its gyrations for the chance of potentially higher returns. Investors looking to net higher returns must almost always accept more risk in what is known as the risk/return trade-off or eat well/sleep well. In other words, risk tolerance.
A risk-averse investor is generally more at ease in a portfolio with few, if any equities, more high-quality bonds and cash. A risk-tolerant investor likes more exposure to equities and other historically more volatile assets. Accessing your level of risk tolerance helps you and your advisor line up the correct investment portfolio for you.
Determining your appetite for risk, an advisor may give you a risk-tolerance questionnaire. Questions range from general circumstances such as your age and your next major expense to your market and income expectations and future money use.
Other questions may present thrill-seeking scenarios:
· Say one of your investments loses 14% of its value a short time after you buy it. What do you do?
· Which of these investing plans would you choose for your investment dollars: maximum diversity; high rates of return and moderate risk; highest rate of return and most risk?
· Assuming you are investing in a stock, which one do you choose: companies that may make significant technological advances but are still selling low; well-known companies with potential for continued growth; blue-chip stocks that pay dividends?
· You have just reached the $10,000 plateau on a game show. Now you must choose between quitting with the $10,000 in hand, or betting it on a 5% chance of winning $100,000. What do you do?
Your answers may change depending on the day – literally. On any given day, even at any given hour, the market could be way up, way down or flat. The deeply risk-averse may feel risk tolerant in a bull market – who doesn’t? – but that same investor may run for the antacids the second the market drops. Your real appetite for risk appears in bear markets.
We invest in a market that blows both bullish and bearish. Find a professional that asks questions and takes the time to get to know you. Yes, a risk-tolerance questionnaire can help but should be only a piece of the conversation. You can ask yourself questions, too:
Imagine I have $100,000 invested and in two weeks it grows to $150,000. How do I feel? In another two weeks it plummets to $75,000. How do I feel?
Your answer will determine whether you grin in expectation or run to the medicine cabinet.
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Sterling Raskie, MSFS, MBA, CFP, is an independent, fee-only financial planner at Blankenship Financial Planning in New Berlin, Ill. He is an adjunct professor teaching courses in math, finance, insurance and investments. His blog is Getting Your Financial Ducks in a Row, where he writes regularly about investments, retirement savings and financial planning.
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