How to Discover Your Risk Tolerance for Investing

By Bill Martin

But no one can tell you what is too conservative or too risky for you. (It is literally against the law for anyone but you to determine your own risk tolerance.) You’re going to have to answer that question on your own.

Two Sides of the Coin

The riskiest strategies are ones that “bet” invested dollars on very specific things, like a single company’s performance, the value of commodities, currencies or even hedge funds. In some of these investing scenarios, people who put their money at risk end up making huge returns. Just as often (and perhaps more so) investors lose some or all of their initial funds, which makes the risk not work taking for many. To have a shot at the big upside, you’ve got to be willing (and able) to suffer the down side.

On the other end of the spectrum, someone who is completely risk-averse might keep all their money as cash under the mattress, a certificate of deposit or other interest bearing account. While you might argue that such individuals aren’t really investing, they are actually investing in cash, and betting that the value of their cash will keep pace with inflation. Often it doesn’t, but depending on your own situation, losing buying power against inflation is not nearly as bad as losing all your funds!

Losing buying power isn’t the only risk in being more conservative than you should be. It could mean that you guarantee you’ll never have enough to retire! Conservative strategies simply rule out the big up side, to reduce the possibility of a big down side. Small as the risk may seem, as we said in the beginning, all investing carries risk.

Your Gut Instinct

You may be sitting at home watching the stock market go up and thinking, yeah, I want those kinds of returns! You first have to decide if you have the stomach for it. Could you stand to watch your nest egg fluctuate with the markets? Do you get excited about plowing in more cash when you see a buying opportunity? What about small caps vs. blue chips? Or taking big positions in single companies? Sure, a lot about your personal situation can and should dictate your risk tolerance, but on a more basic level, people are wired differently for handling the risks they assume.

Studies show that very few stock pickers ever do better than the market average. That’s good news for people who can’t bear to watch, and would prefer to own an index fund that tracks the market as a whole. You could also buy various types of government bonds, and lock in expected returns for years down the road. They won’t be big returns by any measure, but they might be the right ones for you.

Some people equate investment strategy with buying insurance, they’re just different kinds of “bets.” As an investor with a high risk tolerance, you’re betting that you can recover your losses (and possibly make more) before you need to use the money. As a driver with a high risk tolerance, you might figure that you’re unlikely to crash your car, so you bet the cash replacement value of your car against the lowest auto insurance coverage allowed in your state. It might sound funny to think of it that way, but really, investing and insurance are about what you come out with on the other side. How you choose your auto insurance might tell you something about your investing strategy.

How Much Time You Have

Let’s say you have $10,000 to invest. How long are you willing or able to invest it? The longer you can keep it invested, the more risk you can typically handle. If the market has a terrible year and your investment is only worth six thousand dollars, it’s not going to create a critical situation if you have nine more years to stay invested. You have plenty of time to make back your losses. On the other hand, if you have to have your money back in six months, you’re not going to get it.

A five-year strategy is usually different from ten, and certainly from twenty or thirty years. More importantly, the power of compound interest is only realized over time. A handy way to think of it is the time it takes to double your money based on an average return. So, if you averaged a 6 percent return on your investments, your money would double in about 12 years. That’s nothing to sneeze at, but you need time to put your money to work.

How Much of Your Wealth Is Invested

Another factor affecting your risk is the amount of money you have invested versus the amount you have. If you’ve got fifteen grand to your name and you invest ten of it, losing it could be a huge problem, especially if you need it relatively soon. On the other hand, if you have another ninety grand in the bank, losing ten grand is not exactly cataclysmic.

Not only is the percentage of your assets important, but so is the percentage you are able to put in any given investment. The more you diversify, or spread things around, the less risk you have, on balance, even if some of your smaller investments are considered very risky. If for example you invest your entire nest egg in technology stocks and the techs have a bad year, you could lost most of your net worth and never recover. However, if you invest in different sectors like technology, energy, financial, transportation, and health care, you are decreasing your risk by mixing the good and the bad. The odds that every sector is going to have a meltdown are significantly lower. However, as we all know, sometimes every sector in the market can get hammered, which is why there are many investment opportunities outside of just stocks.

The bottom line here is that no one can tell you what is or is not too risky. People will try to, but you’re the one who has to sleep at night while your money is out there going up and down. You’re also the one who will have to live off of your investments when you retire. Determine what you are comfortable with before you invest, and remember one of the best things you can do to lower your risk is to give your investments time. The more time the better.