Understanding risk tolerance
Canada Life - Oct 31, 2023
Risk tolerance measures your willingness and ability to handle a loss in the value of your investments. Understanding your risk tolerance can help you prepare for market changes and save you a lot of stress
Risk is often considered a negative word, but it doesn’t have to be. When you plan for the long term, understanding of your risk tolerance can put things in perspective.
What is risk tolerance?
When talking about investments, your risk tolerance is an assessment of your willingness and ability to handle a loss in your investments’ value due to market volatility.
How much risk are you willing to take?
Your willingness to take risk is tied to your personality and how much you’ll worry about your investments.
If you worry when the market changes, you probably have a lower risk tolerance and might prefer investments less likely to lose money but that offer a lower return.
If you’re willing to leave your money alone and stick to your long-term investment plan through ups and downs in the market, your probably have a higher risk tolerance.
If you aren’t sure what you’re comfortable with, ask yourself:
- Do I need the money I’m investing in the short term or long term?
- How would I react if my investment dropped significantly in value?
Understanding your risk tolerance can help you prepare for market changes and save you a lot of stress. I can help you determine your risk tolerance by working with you.
What is your ability to recover from investment loss?
The younger you are, the more time you likely have to recover from market downturns – particularly when it comes to your retirement savings. If you’re in your 20s and are saving for retirement, you should be better able to handle short-term changes in your investments.
Factors like your income and other assets also play a role in your ability to take on risk.
Risk capacity is your ability to survive financial loss if your investments take a steep drop. If you have a higher risk capacity, you can stay the course and hopefully rebuild your assets over time.
If you have a lower risk capacity, you’d be severely impacted if the market dropped. For instance, if you’re retiring soon, you probably wouldn’t want to put a big chunk of your savings into a risky investment.
That’s why it’s important to adjust your risk tolerance as you age and your life changes.
Types of investment risk
When it comes to determining your risk tolerance, you’ll want to consider the various risks that go along with investing.
Inflation could cause the money you’ve invested to decline in real value. In other words, the rate of return you get on your investments is lower than the rate of inflation on the goods and services you’ll buy in the future.
A fall in an investment market, such as the bond market or stock market, could cause a drop in the value of the investment you’ve chosen. This is called market volatility and there can be many reasons it happens.
If you invest heavily in a particular industry or environment, you risk the value of your investments could be affected by an issue specific to that industry such as a strike or lack of materials.
When you make investment decisions, you could buy or sell an investment at the wrong time. People try to buy low and sell high but assessing market conditions takes more experience than most people have.
The best way to manage the first three risks is to diversify your investments with a mix across different sectors, markets, countries, types of investments and investment styles.
To help manage timing risk, you might consider purchasing your investment using dollar-cost averaging.
With dollar-cost averaging, you invest the same amount of money on a regular basis, regardless of the price of the investment. Over time, investing this way can lower your average cost per unit compared to what you would have paid if you had bought all your units at the same time when they may have been more expensive than average.
Levels of risk tolerance
Risk tolerance comes down to your comfort level and preferences and our real-world financial situation. It’s important to balance these. If you’re very willing to take risk, but unable to recover from market drops, you could run into real challenges.
Once you determine your risk tolerance, you’ll be able to recognize the type of investor you are.
Your risk tolerance and capacity are lower. Your investments will likely include a few stocks and more bonds or money-market assets which usually offer steady returns with less fluctuation in price.
You’re somewhere in the middle. You may you have a higher risk tolerance but a lower risk capacity or vice versa. Your investments might include a mix of stocks and bonds for a more balanced approach.
You have a higher risk tolerance and capacity. You accept you might see big swings in your investment value over time. You’re likely looking for bigger potential returns. Your investments are likely mostly stocks (as opposed to bonds) from big and small companies.
You can even choose managed solutions that offer diversification and are prepared for specific levels of risk.
You’re in control of assessing your risk tolerance and how much risk you take on. But you don’t have to do it alone – I can help.