Your appetite for risky activities, like skydiving, is unique. The same goes for investing.
Have you ever been skydiving or parachuting? Are these activities on your bucket list? Or does the thought make your stomach churn? Maybe the adrenaline rush you once enjoyed is less appealing now.
Just like your appetite for risky activities is unique and can change, your risk tolerance when investing depends on many factors.
What’s your risk tolerance?
When you build an investment portfolio, 1 of the factors you need to take into account is your risk tolerance. Part of determining your risk profile is looking at how aggressive your investment goals are and when you need to reach them. For instance, is retirement 20 years away? Are you planning on buying a home in the next 5 years? Are you putting aside education savings for the kids?
You should also explore how you’d feel if your investment account balance varied. While riskier or more aggressive assets potentially provide a higher return over the longer term, they may also shift more in value.
Understanding your goals
Your investment portfolio should be part of your overall financial plan. Your financial plan lays out your goals and outlines investment strategies to achieve within your set time period, also known as a time horizon. This framework helps you determine the degree of risk that you want to accept to reach your investment goals. If you have more time to reach those goals, you generally have greater capacity for risk.
It’s also important to understand what investment return you’d like to achieve. A higher return expectation means you may want to consider riskier assets.
For example, let’s say you’d like to retire in 20 years. You’ve determined that you need about an 8% annual return to meet that goal. When you look at risk-free investment options, like guaranteed investment certificates (GICs), they may not offer high enough returns to meet your investment return goals. This means that, to save for retirement, you may want to consider other options which carry more risk, but offer higher potential returns.
When it comes to choosing specific investments, start with identifying options that are suitable. Take into account your time horizon and income needs. Fixed income products are generally considered more conservative, while equities are typically more aggressive. It’s also possible to blend several different asset classes in a way that raises your potential return without increasing risk. You always need to consider your portfolio as a whole.
Feeling comfortable with your investments
While using a practical approach to investing is important, don’t be surprised if emotions affect your risk tolerance, too. That’s why you should also consider how you may react to shifts in the market, also known as market volatility. Market ups and downs may not happen often, but they can be dramatic when they do. In a volatile market, an aggressive portfolio may shift more than a conservative one. Changes in your account balance can tempt you to abandon your plan. It’s sometimes hard to anticipate how you’ll feel before these market events occur.
Your emotional risk tolerance evolves as your financial situation and goals evolve. Your risk tolerance may increase as you build assets and become used to the ups and downs of financial markets. It may also decrease when you encounter stressful life events, like divorce, or when you are closer to needing the money.
The yin and yang of portfolio building
Balance is key when considering your expectations and risk tolerance. Remember, these aren’t set in stone. Both can shift depending on life circumstances and financial market developments. You should update your financial plan periodically to help ensure it continues to reflect your overall investment goals, timelines and comfort level with risk.