15 Oct, 2016 –
Understanding Your Risk Tolerance
Do you fill the gas tank when it’s half full or do you keep driving until the needle reaches empty? Do you brake when the traffic light turns yellow or do you accelerate through the intersection?
Your daily actions are a reflection of your attitude toward risk and your ability to accept or tolerate risk. In the world of investing, this can impact how you build a portfolio because you need to consider the level of risk you can handle as an investor, according to wealth advisor Matthew Forney, with Tompkins Financial Advisors in Ithaca, NY.
Risk Tolerance in Investing
When considering purchasing an investment, it is essential to evaluate two aspects of risk tolerance: (1) your capacity for risk, or ability to absorb losses; and (2) how comfortable you are with risk.
Your capacity for risk tolerance relates strictly to your financial situation, says Forney. The key question you should ask is: How much money can you afford to lose? If you depend on your investments to cover daily expenses and would consider a loss a serious problem, you have less risk tolerance than someone who would view an investment loss as merely an inconvenience or disappointment.
From an emotional standpoint, your comfort level with risk depends on many factors, including your objectives and goals, life stage, personality, knowledge about investing and investment experience. You should only invest as much as you’re comfortable with. If you find yourself worrying excessively about your investments, it might be time to dial it back a bit.
Investors generally identify with the three categories of risk tolerance: aggressive (risk tolerant); conservative (risk adverse) or moderate (somewhere in between.)
Your risk tolerance will change over time, depending on your age, income, and life situation. As these factors change, your risk tolerance will rise or fall. Forney, and the team at Tompkins Financial Advisors, advise clients to to monitor their risk tolerance, and pay attention to the way their attitude toward risk may affect their judgment.
Relationship Between Risk and Return on Investment
One factor that is key to understanding risk is the risk-return tradeoff. As risk grows, the potential for return also grows. Investments with higher risk historically have tended to provide higher returns, though past results are not guarantees of future returns. Investors who are more aggressive and take more risk have a greater chance of earning potentially higher returns (if any return is earned at all). At the other end of the spectrum, investors who are more conservative and take less risk, generally have a lower potential to earn a high return (though you are less likely to lose your principal).
Another key aspect of evaluating your risk tolerance is determining the length of time you plan to stay invested in a particular financial product. If you foresee a long time horizon, you may be able to invest more aggressively in higher-risk investments, because you’ll have more time to ride out fluctuations in the market.
Beyond your own propensity toward risk, each investment can be affected by the general risks associated with that type of investment. Any particular investment can face risk because of circumstances related to a specific company, industry or class of investments.
Measuring Your Risk Tolerance
You can measure your tolerance for risk by taking one of two tests: an investment preference test or a psychological test.
An investment preference test is a questionnaire that records preferences for certain types of investment vehicles. Your current financial situation, goals, and past investment experience are all factors evaluated on the test. While this type of test is easy to construct and relatively simple, it may not accurately assess your propensity for risk because it does not address your emotional reactions to risk.
If you opt for a psychological test, you will answer questions about your feelings or behavior and respond to hypothetical situations. This type of questionnaire can be easy to administer and fun to take, but its disadvantage is that people who consider themselves risk-takers my not respond as accurately as they should, and ultimately they may find out that they are more risk-adverse than they had thought.
Assessing your tolerance for risk in investing is not an exact science, and tests designed to measure your propensity toward risk are not completely accurate. It is helpful to consult a financial advisor to determine the type of investments that will accommodate your tolerance for risk and meet your financial goals.
Some of this material was prepared by Forefield/Broadridge for Tompkins Financial Advisors. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
We suggest that you discuss your specific situation with your financial advisor prior to investing.
Investing involves risk including loss of principal. No strategy assures success or protects against loss.
Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC. Insurance products offered through LPL Financial or its licensed affiliates. LPL Financial is a separate entity from Tompkins Financial Advisors. The investment products sold through LPL Financial are not insured Tompkins Trust Company deposits and are not FDIC insured. These products are not obligations of Tompkins Trust Company and are not endorsed, recommended or guaranteed by Tompkins Trust Company or any government agency. The value of the investment may fluctuate, the return on the investment is not guaranteed, and loss of principal is possible. Tompkins Financial Corporation, Tompkins Trust Company and Tompkins Wealth Advisors are not registered broker/dealers and are not affiliated with LPL Financial.
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