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Risk Tolerance
- Ethan Qian-Tsuchida
- Jan 26
- 4 min read
Updated: Feb 17
What is Risk Tolerance?
Risk tolerance is the level of risk you’re willing to take on in exchange for potential rewards in your investments. Without assessing risk tolerance properly, you might end up with investments that aren’t aligned with your goals or emotional comfort level. This misalignment can lead to poor decision-making, such as panic selling during market downturns or holding onto investments that don’t match your long-term objectives.
It’s important to understand that your risk tolerance is not fixed. It changes over time, depending on factors such as:
Age: The younger you are the higher risk tolerance you may have because you have more time to recover from losses. While as you get older, especially nearing retirement, you may prefer more stable investments.
Time Horizon: The length of time you plan to invest also affects your risk tolerance. If you’re investing for a long-term goal such as building your children's college fund, you would be more willing to weather short-term volatility in hopes for greater long-term gains.
Financial Situation: A more stable high income and certainty of future expenses may increase your risk tolerance.
Personal Preferences: Your comfort level with uncertainty plays a key role. All final calls are yours and you should be confident in your entries and exits.
How to Assess Your Risk Tolerance
1. Assess Your Financial Situation
Consider your current and future financial circumstances:
How much money do I have available to invest?
Do I have an emergency fund or other sources of income to rely on in case my investments lose value?
Am I prepared to accept potential losses in the short term for the possibility of higher returns in the long term?
The more disposable income you have, and the fewer immediate debt obligations you face, the more risk you can afford to take. If your financial situation is precarious, you may want to opt for a more conservative investment approach.
2. Consider Your Investment Time Horizon
To reveal your time horizon, determine your short-term and long-term goals (e.g. buying your first car or saving for retirement) and when you want them to be accomplished by. A longer time horizon generally allows you to weather more volatility, making it possible to invest in riskier, higher-return assets like stocks. Shorter time horizons, however, require more caution since you may need to access your investments sooner, making it harder to recover from market downturns.
For example, when investing for retirement (a long-term goal, 30 or more years down the road), you may want to take riskier investments. A counter example would be if you’re saving for a down payment on a house in the next 3-5 years, you may want to take safer, more stable investments like bonds or mutual funds.
3. Understand Your Emotional Comfort with Volatility
Risk tolerance isn’t just about numbers; it’s also psychological. Consider how you feel about market fluctuations and the possibility of losses. Are you comfortable with the idea of your investments going up and down in value, or does it stress you out? Would you panic if your stock portfolio suddenly dropped by 20%?
If you can see yourself panic selling off investments during market downturns, you may want to invest in less volatile assets.
4. Use Risk Tolerance Assessments
Many financial institutions offer risk tolerance assessments that can help you better understand where you fall on the risk spectrum. These tools typically ask a series of questions about your financial goals, time horizon, and reactions to hypothetical market scenarios and based on your responses, will categorize you into a risk profile.
These assessments are a helpful starting point, but remember, they’re just tools. They can give you a framework for understanding your risk tolerance, but it’s up to you to determine what feels right based on your personal preferences and financial situation.
Aligning Your Risk Tolerance with Investment Strategy
Once you’ve assessed your risk tolerance, it’s time to align it with your investment strategy and trading plan. If you determine that you have a high risk tolerance, you might consider investing in assets like stocks, growth funds, or even venture capital. If you’re more risk averse, bonds, dividend-paying stocks, or mutual funds may be more appropriate.
Additionally, remember the principle of diversification. You shouldn’t put all your eggs in one basket. The baskets in this case being risk tolerant and risk averse. You can choose to allocate certain portions of your whole portfolio to different categories of risk, based on your determined risk tolerance.
Flexibility is Key
Risk tolerance isn’t a static trait, since it can change as your life circumstances evolve. Regularly reassessing your risk tolerance is essential for staying aligned with your financial goals.
By understanding and evaluating your risk tolerance, you’ll be better equipped to make informed investment decisions that reflect both your financial needs and your emotional comfort level.
In Conclusion
Understanding your risk tolerance is crucial for becoming a successful investor. Doing annual or biannual reassessments of your risk tolerance may seem time consuming initially or even annoying, but it’s essential to protect and achieve both your life and financial goals.
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Written by Ethan Qian-Tsuchida
Newton South High School student
Interests in finance, economics, risk management, and teaching others about fun topics to make the world of finance and economics approachable.
Email - ethan.qiantsuchida@gmail.com
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