Basics Beginner: Risk Tolerance

Introduction to Risk Tolerance Risk Tolerance vs Risk Aversion Determining Your Risk Tolerance Managing Investment Risk Summary of Risk Tolerance
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Determining Your Risk Tolerance

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Determining Your Risk Tolerance

Many investment advisors have developed questionnaires designed to help determine an investor’s risk tolerance (a Web search will give you lots of examples of questionnaires you can take online). They vary from the brief to the meticulous, but they all tend to feature similar kinds of questions and attempt to place you into one of three categories based on your investment risk tolerance:

  • Conservative investors are those who put a premium on conserving their capital and are willing to accept lower returns in exchange for less risk.
  • Aggressive investors seek to get the highest potential growth in value from their investments and are more willing to risk the possible loss of capital to meet their objectives.
  • Moderate investors are (surprise!) somewhere in between.

Questions to ask yourself

So, are you conservative, moderate, or aggressive? Here are some questions that can help you decide.

  • How badly do you need your investment capital? If you are investing funds you will not need to live on or use to meet emergency expenses, you face fewer negative consequences if you lose your capital value in the short term. If you are a retiree investing your retirement nest egg for current income, or taking out a second mortgage on your home, you will likely need to be more conservative.
  • How long can you hold your investments before you cash them in? Holding a more volatile investment, like common stock, for a long period of time allows long-term growth trends to overcome short-term ups and downs in its values. You can afford to be more aggressive if you can let your investments ride for ten or twenty years than if you will need the cash to pay Junior’s college tuition next year.
  • How personally involved do you want to be? Risky investments may require much research and careful monitoring, along with a fair amount of expertise. If you are not willing or able to manage a risky investment, you may have to pay someone else—your broker—to do it for you, or stick to less-risky investment instruments.