Self-knowledge is one of the best tools you have when you invest. Understanding yourself can help you build a portfolio that works for you, and it can keep you from acting impulsively in a way that damages your long-term returns.
What is Risk Tolerance?
Risk tolerance is just what it sounds like: A measure of how much risk you can handle as an investor.
There are some of the factors that go into your risk tolerance:
What you can afford to lose: How much money do you have available? And how much of it can you afford to lose? This is about more than whether or not you have sufficient assets to handle capital losses; it's all about whether or not you can have the money locked away. Can you afford to put $400 a month into an IRA without stretching your finances to the breaking point? If not, consider committing a little less.
Your time frame: The length of time remaining until you reach your goal matters when it comes to how much risk you can handle in your portfolio. Retirement is a good example. As you approach retirement, you have a lower risk tolerance, since you don't have decades to rebuild if a riskier investment causes problems. Take into account the time frame in question as you determine your risk tolerance.
Your emotional ability to handle risk: Not only does risk tolerance include your financial ability to handle a certain level of risk, but also your emotional ability to deal with risk should be considered. If risky investments are going to stress you out to the point that it affects you in other areas of your life that can be an issue. It also matters if you are so risk averse that you never include investments that can grow your wealth.
Risk tolerance changes over time. Age, income, and circumstance all interact to form your current level of risk tolerance. As various factors change in your life, you will find that your risk tolerance rises or falls. Pay attention your current risk tolerance, and be aware of the way your feelings about risk are affecting your judgment.
Compensating for Risk Tolerance
Sometimes you have to compensate for your risk tolerance. If you have a high risk tolerance--particularly if you enjoy taking risks--it can lead to overconfidence in your investing. You might decide that you can "afford" a course of action that you really can't. You might also try to invest in riskier assets and schemes, and overextend yourself.
Having a high risk tolerance might also make you more vulnerable to scammers. According "Outsmarting the Scam Artists," by Doug Shadel, those with more assets tend to be those most likely to be scammed. Your penchant for risk, and the high returns that come with it, could spell trouble for your portfolio.
You need to compensate for this problem by dialing it back a little bit. Be sure to keep part of your portfolio in less risky investments to serve as a safety net. Also, be wary of new schemes and "opportunities" that might actually be scams.
On the other side are those with very low risk tolerance. If you have a hard time taking your investing outside of cash products and bonds, you could find yourself in trouble. You won't be able to build wealth at a rate that will allow you to secure your financial future. To compensate for this situation, consider low-cost index funds.
The important thing is to know yourself. You need to be aware of your weaknesses when it comes to investing, and be honest about what's coming if you expect your portfolio to provide you with long-term wealth.
Miranda is a freelance contributor to several investing and personal finance web sites. She also writes for her own blog, Planting Money Seeds.