Every investor knows that risk and return go together. Generally, lower returns mean lower risk and vice versa. When it comes to risk tolerance, though, everyone’s different and how much you can endure on the downside depends on several factors, including years to retirement, lifestyle and more.
Generally, there are three types of risk: Conservative investors usually stick with bonds, GICs and market funds. Moderate investors will take more risks and invest in growth stocks and mutual funds. More aggressive investors aren’t afraid to put their money in more unpredictable investments that can go up and down dramatically.
Sandra Sigurdson, Investors Group Director of Strategic Investment Planning, says that most investors are a combination of these three ‘types’ and to figure out where you are on the risk-reward investment scale, “You need to know your personal tolerance for risk,” she says. “Risk tolerance is subjective. For some investors, losing a few thousand dollars is no big deal. For others dropping even a couple of hundred dollars is a big deal.”
Along with an advisor, investors must figure out how much risk they can take on. Don’t do it right and you could end up panicking when the market falls.
Risk tolerance is also both financial and emotional. “For financial, it’s about needing to make the investments that meet the objectives of a long-term financial plan,” she says. “For emotional it’s about making investments that don’t stress you out and negatively affect other aspects of your life.”
Along with an advisor, investors must figure out how much risk they can take on. Don’t do it right and you could end up panicking when the market falls. Here are five things to consider when determining your risk tolerance.
Do you understand the market?
One thing to consider is your market knowledge. “If Alpha and Beta are all Greek to you, consider wading in slowly, especially if you’re just starting to invest,” says Sigurdson. “If your nest egg is small, the payoff for taking risk is not that significant in dollar terms – so take it slow until you grow your confidence and understanding.”
Have you experienced losses?
If you’ve been through a downturn before, then think about how it made you feel. “Did it cause you to pull back on your investments and perhaps sit on the sidelines or move into ‘safer’ investments? Did it cause you emotional turmoil or were you able to stick to your plan, participate in the recovery and get on with your financial life?” asks Sigurdson. “Answering those questions will give you a good read on your risk tolerance.”
Are you afraid of uncertainty?
In other aspects of your life do you avoid uncertainty or embrace it? “Your tolerance for uncertainty in your work life and the people you choose as friends is a good indicator of your tolerance for uncertainty in the value of your investments at any given point,” she says.
Do you have other money elsewhere?
If you have other sources of income, like a pension or maybe a sprawling estate you can one day sell, then you may be able to take on more risk in your portfolio. “If you are dependent on your investment dollars to live, you have less capacity for risk,” says Sigurdson.
Are you aware of what you can lose?
Research has found that if you put potential losses in percentage terms, you won’t really be able to evaluate how much of decline you can stomach. Put it in dollar terms instead. “Instead of a 30% drop, tell yourself that it’s a $30,000 drop,” she says. “How would that feel? What would you do?”
Once you’ve figured out your personal risk, what next? Well, as Sigurdson says, the good news is that there are ways to maximize the potential for higher returns in your investment portfolio and manage risk at the same time.
“Stay the course,” she says. “Markets fluctuate but study after study has proved that time in the market delivers much better returns than trying to time the market. Spread out the risk by diversifying your portfolio and use asset allocation to assemble the mix of investments that best suits your goals and risk tolerance.”
Finally, build the right portfolio and you won’t have to worry about risk. “Build something that has the right level of risk and the right risk management strategies for you,” she says.