The first step to becoming an investor is understanding your risk tolerance. It's a concept that often gets overlooked, yet it's crucial for making informed investment decisions.
When you are fully aware of how comfortable you are with risk when it comes to investing, you will make better investment decisions. Ignorance in this area can lead to poor investment choices and, ultimately, financial loss.
Here's how you can understand your risk tolerance and use it to guide your investment strategy.
Defining risk tolerance
Risk tolerance is the level of risk you are comfortable taking on in your investments. It's not just about the numbers. How you feel and cope when your investments go up or down are signals to your appetite for risk. Look at how you respond to market shifts, volatility and price fluctuations, which are inevitable, and how you feel is a strong indicator of how you’ll handle your relationship with investing your money.
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Pro tip: If the thought of losing money keeps you up at night, you likely have a low risk tolerance.
Time horizon
Break down your financial goals into short-term and long-term. Short-term money goals are like purchasing a CD for 1 year, saving up to buy a car or setting aside funds for a vacation. Retirement and college for your kids would be long-term goals. Your risk tolerance will vary depending on the time horizon of each goal.
When it comes to investing, time horizon is crucial because the more time you have, the more time your money can grow through compounding.
Investing calculators
Many online platforms and financial advisers offer calculators to help you make investment decisions. These calculators give you a clearer picture of your risk tolerance, which you can then use to tailor your investment strategy. are free to use and don’t require you to sign up. These online tools allow you to compare investment options.
Align investments with risk tolerance
Once you understand your risk tolerance, the next step is to align your investments accordingly. For those with a low risk tolerance, bonds, low-volatility stocks or high-interest savings accounts may be more appropriate. If you have a high risk tolerance, you might be more comfortable with investments like real estate rentals or high-growth tech stocks.
Remember, investors need to think beyond potential returns. A balanced portfolio, based on your situation, is key.
Be flexible
Your risk tolerance isn't set in stone. Life events like marriage, having children or changing jobs can all impact how much risk you're willing to take on. Make it a habit to review your risk tolerance and investment strategy at least once a year or after any significant life change.
Talk to a financial adviser
If you're unsure about your risk tolerance or how to align it with your investment strategy, consider consulting a financial adviser. They can provide personalized advice tailored to your financial situation.
Bottom line
When you understand your risk tolerance, you will make better decisions that align with your comfort level and financial goals. By taking the time to deeply understand and assess your risk tolerance, you're setting yourself up for long-term investment success.