Choosing Your Risk Tolerance
The more your money has the potential to grow, the more it also has the potential to shrink. How much you are willing to see it go either way is referred to as your risk tolerance. In investing, there are no guaranteed returns, with certain government bonds being the notable exception, and so every investment comes with the chance of loss. Generally, the greater potential gain, the greater potential loss. A smart investor looks for ways to maximize potential gain while minimizing potential loss, but the possibility of losing money on an investment never completely goes away. That potential - both likelihood and degree of loss - varies significantly between investments.
The concept of risk tolerance is closely associated with the principle of diversification. The less diversified your portfolio, the higher the risk tends to be. This makes adequate diversification especially important for smaller and less risk tolerant investors. How you diversify your portfolio to moderate for risk will change over time, depending on your time horizon, or how long you have until you expect to need the money that you have invested. Generally, longer time horizons can accept greater risk tolerance, because you have the time to ride out any temporary market downturns, while shorter time horizons are better off with less risky investments, to safeguard the returns that you have already captured.
When deciding upon your personal risk tolerance, consider the following broad categories:
- Conservative: an investor who does not want to lose any of their principal, and is fine with investments that are below inflation. This investor may be depending on income from the investments for their daily living expenses, or may have a very short time horizon
- Moderate: the most common type of investor, the moderate wants to keep up with market returns while protecting themselves against the worst dips in the market. Typically, this investor will have specific long-term goals in mind, like retirement or educational costs
- Aggressive: an ambitious investor for whom "average" isn't good enough. They are comfortable seeing large fluctuations in the value of their portfolio. Typically, an aggressive investor will have their short- and long-term investment needs already taken care of, and so they can absorb losses without affecting their quality of life
It is not uncommon for an investor to have a risk tolerance level somewhere between these categories, or to have some investments at one risk tolerance level, and other investments at another. Risk tolerance affects not only the style of investing, but the types of investing that an investor will hold:
- Conservative portfolios will use many government and high quality bonds to keep the risk low
- Moderate portfolios will combine value and growth stocks, often using ETFs to ensure adequate diversification
- Aggressive portfolios may contain mostly small-cap and other speculative stocks, and be less diversified
Your risk tolerance will change over time, so be sure to update your portfolio accordingly.