When you invest your money, you could accumulate earnings, or suffer losses. If you are able to handle a loss without significantly altering your lifestyle, you have a high-risk tolerance. On the other hand, if a loss would devastate your finances and your life, you probably have a low risk tolerance. Therefore, before you invest, carefully evaluate your ability to withstand the worst-case scenario with your portfolio.
Here are three of the most prominent areas that affect your risk tolerance:
- Age and Time Horizon- Usually, the younger you are, the longer your time horizon. For example, assume your goals include personal savings and accumulating assets for your retirement. If you’re young, say 30 years old, this can represent a long-time horizon. You may be able to withstand the ups and downs of the market over that time frame. Therefore, you may have the capacity to assume more risk. On the other hand, if you’re close to retirement, you may be hesitant to place your assets in volatile, aggressive growth or lower grade investments—they may have a lower value when you want to sell them for income during retirement. Given this situation, you would probably have a relatively low risk tolerance.
- Net Worth and Liquid Assets-If you take your total assets (what you own) and subtract your liabilities (what you owe), you arrive at your net worth. When considering investments, you should use your net worth as a guide to help plan your portfolio. If your liabilities exceed your assets, you have a negative net worth, and you should carefully consider the risks you face. You may want to concentrate on reducing your debt and developing a positive net worth. A positive net worth indicates you have covered your liabilities with current assets and have a greater capacity to assume risk. However, the next question is: How much of your positive net worth is liquid? Liquidity is your ability to readily convert an asset to cash without an appreciable decline in price. If most of your net worth is illiquid, you may have to lower your risk exposure and invest with liquidity needs in mind. On the other hand, if your net worth is mostly liquid, you may have the capacity to accept more risk in your investment portfolio.
- Debt Structure-Finally, you should review the type of debt you are holding. Mortgages and equity loans usually carry lower interest rates than credit card debt. If you maintain significant balances on your credit cards each month, you may want to pay them off to reduce liabilities and eliminate payment of nondeductible interest. In addition, total your monthly debt payments. Debt is considered high when it represents 35% or more of your monthly gross income. Consider implementing a practical plan to lower debt over a sensible period of time. After you have reviewed these areas and have measured your risk tolerance, you are ready to choose investment strategies that best fit your situation.
"Risk-How Much Can You Handle."FMeX. 2015.
