Do you know how high your risk tolerance is?
Risk tolerance is your willingness to take the risk for a potential reward. It is often the basis of how you invest and how you spend your money.
Some people throw their money into every fad, opportunity, and hot new investment they come across. You have a high tolerance for risk.
Other people hoard their money in savings accounts and never touch it. You have a low tolerance for risk.
As with most things, the sweet spot for risk tolerance is somewhere between the two. However, there are many factors that will determine where your tolerance for risk lies and it is important that you are aware of them.
What is your risk tolerance?
How did you feel this year as coronavirus fears surfaced and markets fell? Did you respond by buying, holding, or selling more stocks?
Big market dips and your reaction can tell a lot about you as an investor.
Risk tolerance is Not How Much Risk Can You Take? Your risk tolerance is how well your portfolio can handle market losses. For example, if you have a lot of money and are living well within your means, you can probably deal with the economy getting into a rough patch.
However, your real tolerance is your emotional risk capacity and investment behavior.
Your portfolio must reflect your tolerance. For example, if you invested fully in stocks but were not entirely comfortable with the risk, you would likely start selling during a downturn. As we’ve seen from the past, this means you are missing out on potential gains from these stocks.
If you had more of a mix of stocks and bonds, you might feel comfortable taking the risk of a downturn and sticking to it to see the rewards.
People are often emotional investors. If you are extremely sensitive to the changes in the market, you need to take this into account when building a portfolio. The more honest you can be about your comfort in investing, the more likely you are to build a portfolio that will serve you well.
This is how you finally use your risk tolerance
A well-rounded portfolio can be built up in a variety of ways. You may have a high tolerance for risk, but your portfolio doesn’t have to be very aggressive to meet your financial goals.
Risk tolerance is only one component of total investment needs.
We also need to consider your goals, your stage of life, and your individual situation in order to find out what is best for you.
A good financial advisor will know how to evaluate all of these factors and help you create an investment plan.
But you can also work to find out where you stand. First, fill out a risk tolerance questionnaire to get a general idea of where you are falling.
Then write down some rules you have for yourself and when to rebalance. For example, you might choose to realign every year or whenever your stocks are more than 5% off your starting point. The rules can be anything, but the point is to have some guidelines if you are feeling emotionally motivated to make changes to your portfolio.
Knowing more about your behavior will make you a better investor overall. So it is worth getting to know yourself and your tendencies.
If you need help building a portfolio that supports your goals, I can help. Contact me here to make a call.
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