Understanding Risk Tolerance

Whether you’re crossing the street or driving a car, risks are simply a part of our everyday lives. Try to avoid risk-taking altogether and life would come to a grinding halt – after all there’s risk in just about everything we do. Investing is no exception – your financial goals and the time it will take you to achieve them play a part in determining how much risk you can take on.

The amount of investing risk you’re willing and able to take is called your “risk tolerance.” Your risk tolerance is one of many factors your advisor uses to help choose investments that will help you reach your financial goals without exposing you to more loss than you can handle.

The portfolio that is right for you depends on many factors, including how much risk you can tolerate. The best portfolio for you also depends on factors such as your investment objectives and investment time horizon.

Determining your risk tolerance
Your advisor needs to understand what your risk tolerance is before investing your money – it’s a fundamental part of creating a financial roadmap that steers clear of the bumps and pitfalls you can’t handle. Your initial conversation with any advisor should include a discussion about your ability to handle risk – that is, your financial ability to handle an investment loss – as well as your willingness to tolerate risk. This information will help your advisor understand more about your personal and financial circumstances. Your answers will form an important part of your Know-Your-Client (KYC) information, which is the basis of your investing profile.

Here are the main things your advisor should understand about your risk tolerance:

Your ability to handle risk – Your ability to tolerate risk depends on your current investments and savings as much as it does your ability to generate income over time. If you’re working and earning a salary, you have more ability to recover from a loss than someone who is retired and relies on their investment income to meet their day-to-day needs. At the same time, people with large amounts of savings and investments may have more ability to handle a bit more investment risk.

Your willingness to take on risk –There’s also a psychological side to risk tolerance – your advisor needs to understand how willing you are to handle risk in your investments. How would you react emotionally to an investment loss? Would it keep you up at night? Or would you be comfortable with accepting more risk if you thought it could increase your chances of higher returns? Your advisor needs to be aware of how you would feel about a potential loss in order to help you pick investments that reflect the amount of risk you are willing to tolerate.

What your goals are – An advisor can help you figure out ways to balance your ability and willingness to tolerate risk in order to achieve your financial goals. For example, if you are a risk-taker planning for retirement, you need to understand how much money you could lose if you take on too much risk. How would you feel if a loss prevented you from retiring when you want to – or meant that you had to live on less during retirement? At the same time, if you’re risk-averse, you’ll have to consider whether taking on too little risk will generate the returns required to meet your financial goals.

Visit our Investing Basics hub to learn more about investing goals, risk tolerance, choosing investments and tracking progress.

To access our retirement planning, investing and budgeting calculators, visit our calculators hub.

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