Understanding Your Risk Tolerance

Any time you invest in the stock market, you’re taking on a risk. However, it’s important to understand that there are two different types of risk that come with allocating your assets:

1. The unavoidable risk of the market. This is often beyond your control, and you can’t really predict what the market will do on a given day.
2. The risk you choose to take on. You can view this as choosing how you want to approach your investments. You can choose to invest in stock that could be more volatile (but could have a larger pay off over time), or you can play it safe and invest in relatively low-risk funds (or funds primarily consisting of bonds and dividend-paying stocks).

Many people are cognizant of the fact that the markets come with some inherent risk, especially after the recent DOW plunge at the beginning of February 2018 in our not-so-distant rearview mirror. What they often don’t consider is the fact that they have some control over how much risk they want to take on.
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Risk Tolerance v. Risk Capacity

Your portfolio is defined by two things: how much risk you can feasibly take on in order to meet your goals, and how much risk you can actually stomach. Your risk capacity is defined as the amount of risk your portfolio can handle. In many cases, your financial goals may be served with an aggressive investment strategy. This is especially true if you have many years to build a portfolio before you retire. You have more time to recover should the market drop, and your aggressive investment strategy has the potential to have a large payoff (Appreciation).

However, just because you can take on the risk doesn’t necessarily mean it’s the best strategy for you as an individual investor. That’s because investing isn’t just about crunching the numbers. It’s about building a strategy that helps you to achieve your goals without worrying yourself to death with every up and down the market faces. Knowing your risk tolerance can help you to understand just how much risk in your portfolio you can emotionally cope with. A better way of looking at this might be: risk tolerance is knowing how much risk you can take before you make a snap decision - like selling all of your stock and changing strategy when the market crashes and you start to lose money.

Everyone has a different risk tolerance and risk capacity. Knowing yours can help you make smart investment decisions that help you reach your short and long term goals, all while feeling confident in your investment decisions (and not losing your mind every time the markets drop).
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Breaking Risk Strategy into Three Categories

There are three “risk categories” that your portfolio might fall into.

1. Aggressive
   
2. Moderate
   
3. Conservative
   

Obviously, these are generalizations and there’s quite a bit of wiggle room within each category. A question that people often ask to help determine what category you might fall into is: What would you do if the stock market fell by 20% in a year? You might answer:

1. I wouldn’t do anything. I believe that sitting and waiting is the best course of action - the market will correct itself, as will my portfolio.
   
2. I would wait a few months, but then I’d need to decide whether to move forward with my current strategy. I can’t keep losing like this!
   
3. I’d sell immediately - this level of loss is too much for my financial plan to take.
   

Aggressive investors typically are less impacted by market drops. This is because they have a high emotional tolerance for market risk and because they have an investment strategy that supports these highs and lows. Usually, that’s because they have a longer timeline for their investments to grow. For example, if you’re in your 20s or early 30s and are watching your retirement investment accounts grow, taking a nosedive over the course of one year won’t be that big of a deal because you still have forty to fifty years to bounce back.

However, if you have a shorter period of time to wait until retirement, you won’t have as much time to put money into growing your portfolio and your investment/retirement funds won’t have as much time to grow. This puts you at a lower capacity for taking risk on. You might also find that you have less tolerance for risk in these situations, because you know you won’t have enough time to “bounce back” from a large loss.

Just Because You Can, Doesn’t Mean You Should

It’s important to understand not only your risk capacity, but your risk tolerance. In other words: know thyself. Just because you can take on high-risk investment options doesn’t necessarily mean you should. Many people aren’t really involved with their asset allocation with any regularity. The market roller coaster doesn’t impact them emotionally, and they have no intention of touching their investments or getting in the weeds with asset allocation as a result of a market drop.

If this isn’t you, and you know are likely to sell everything when things go south (even if they could bounce back in a day, a week, a month, or a year) - then a lower risk portfolio might be a better option to maintain your emotional health. Ultimately, you need to find a strategy that you can stick with in the long-term.
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Talk to a Professional

There are many tools available to help you determine how much risk you can take on. However, knowing how much you want to take on given your approach to investmenting and money is another story entirely. This is why speaking with a financial planning professional can be helpful.

A financial planner can help you develop a plan that strikes a balance between risk capacity and tolerance, and they can help you to regularly adjust your portfolio as time goes on and your goals shift. At Wisely Advised, we help clients create portfolios that push them toward their retirement savings goals while accounting for how much risk they’re willing to shoulder emotionally. More importantly, we help to alleviate the pressure of adjusting their investment strategy by tracking their investments for them, and rebalancing as needed.

Do you want help building a portfolio with the right amount of risk built in? Set up a free consultation today! We’d love to be on your team when it comes to investing wisely.

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​Tony Velasquez is the Founder and Managing Director of Wisely Advised an Illinois Registered Investment Advisor.  Wisely Advised provides comprehensive financial planning and investment advisory services to both individual and business clients.  You can learn more about Tony and his firm at www.wiselyadvised.com.