You’ll often see investment advice referring to your personal risk tolerance. This can be tricky to understand and apply because it differs from person to person, and it should also change over time as your investment goals evolve. So what exactly is risk tolerance, and how can you better understand this somewhat open-ended term?
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Keep reading for an in-depth look at risk tolerance, what it means and how to determine what yours is.
Also see five things to know if you’re scared to invest.
What Is Risk Tolerance?
One way to look at risk tolerance is through the amount you’re willing to gamble when making investments. That’s ultimately a personal decision, but you can think of it as a combination of your comfort level with potentially losing the money you put into an investment and practical considerations, like how much you can realistically afford to lose.
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How To Determine Your Risk Tolerance
Deciding how you feel about risks might be difficult, but there are some important questions to ask yourself, as well as some concrete factors around which you can base some of your choices.
- Psychological and emotional factors: This is first on the list for a reason. No investment is worth your peace of mind, and if you’re likely to be anxious about potential risks, you’ll want to avoid them as much as possible. You might lose out on some opportunities, but safe, reliable options, like high-yield savings accounts and bonds, might be a better choice for you. Don’t lose sleep over the chance to make money.
- Your financial situation: This may be the most important element when you’re thinking about risk tolerance. Never invest more than you can afford to lose. How much you earn, how much you have in savings, how much debt you carry and your overall financial health are all important things to carefully consider.
- Your age: If you’re a younger investor, you’re likely to have more tolerance for risk because you’ll have plenty of time to recover from any losses. Older investors don’t have that luxury and should ideally be more cautious.
- Your investment goals: Your reasons for investing can be a great way to determine your risk tolerance. If your goal is just to increase your wealth, you might be able to handle riskier but potentially more lucrative opportunities. If you’re saving for retirement, you want a safe, predictable and reliable way to invest.
- Your level of expertise: If you’re new to investing, you likely have a lot to learn and should consider that when choosing investment opportunities. More experienced investors who better understand risk and reward may be able to stomach a little more uncertainty at less peril.
Risk Tolerance and Investment Strategies
Deciding how comfortable you are with risks is just the first part of developing an investment strategy. Knowing how to put it into practice is just as important.
Low Risk Tolerance
Someone who’s likely to worry, older investors, and investors with limited capital or experience should probably adopt a low tolerance for risky investments. This conservative approach emphasizes sure and steady over high-risk, high-reward opportunities. Though you may not enjoy the same returns as investors who are more comfortable with taking on risks, you’ll be shielded from the higher potential for losses.
The following are some relatively safe bets for low-risk investors.
- Fixed-income securities: These are investments like bonds, Treasury bills and other fixed-income financial products that offer regular, predictable interest payments with little risk.
- Dividend-paying stocks: “Blue chip” companies typically have a track record of stability and consistent dividend payments.
- Cash and cash equivalents: These investments are essentially the same as cash and can quickly be converted into liquid — spendable — assets if needed. High-interest savings accounts, certificates of deposit and money market funds are examples of this kind of investment.
Moderate Risk Tolerance
Having a moderate risk tolerance means you might be willing to deal with market volatility or a slightly greater chance of losing your stake for the opportunity to realize higher returns. This is a balanced approach, and it can be a good way to invest for those with a stable income, ample time to plan for retirement and at least a basic foundation in investing.
Moderate-risk investments would include things like the following.
- Balanced funds: Also called multi-asset funds, these are investments in a group of stocks and bonds that offer some insulation from market risks while providing an opportunity for potentially higher returns.
- Diversified portfolio: This kind of investment requires a broker or financial manager or significantly more investment experience than most people possess. A diversified portfolio is a mix of equities, bonds and other balanced assets that are chosen to spread the risk across different kinds of opportunities.
- Real estate: Though not all real estate investments are low in risk, they are generally considered safer than other forms of investing, and opportunities like real estate investment trusts offer greater stability with the potential for a steady income and gradual appreciation.
High Risk Tolerance
If you’re in a position to take a gamble, lose and not be too adversely affected by the outcome, a high-risk approach might be one to consider. It’s not an exaggeration to call these kinds of investments a gamble, as they typically result in losses more often than gains, but they have the chance of sky-high returns. It bears repeating: Never invest more than you can afford to lose.
But if this is a strategy you’re considering, here’s a list of potential options.
- Growth stocks: As opposed to “value stocks,” growth stocks are those of companies with the potential for rapid growth and increasing valuations, though these are generally unpredictable and more volatile investments.
- Sector funds: Also called specialty funds, these include investments across specific industries, like healthcare, energy or technology.
- International stocks: These are generally investments in what are referred to as emerging markets, and though they bring the chance of higher returns, they can be significantly more volatile than other opportunities. Currency fluctuations and political instability are just two of the risk factors associated with this kind of investment.
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This article originally appeared on GOBankingRates.com: Understanding Risk Tolerance and Its Impact on Investment Decisions
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