We are all made of different things. Some of us loved climbing the highest branch of the backyard tree, others were happy to get to the first branch (and then worry about coming down). Some of us take risks in life and in investments. Some of us need a “sure thing”. So how do you find out where you fall on the investment spectrum? Are you a bankrupt investor, someone who plays it safe, or are you somewhere in between?
Risk tolerance is divided into three categories: aggressive, moderate and conservative. If you’re not sure where you’re falling, answering these four questions will give you a better idea.
1. What are my goals?
Ask yourself why you are investing. For example, you want:
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- buy a man
- save for retirement
- resign early
- Travel the world
- Pay for your child’s education
- Once you know why you’re investing, you can estimate how much you’ll need to reach your goal(s) and get an idea of how aggressive you’ll need to be to raise that amount of money.
2. What is my deadline?
Let’s say you’re saving up to buy a house. You would like to have a healthy deposit within three years. In general, the less time you have, the less you can afford the inevitable market downturns and the more conservative your investments need to be.
On the other hand, if you’re looking at a longer-term goal, like paying for your child’s education or retirement, then you can take more risks. This is because you have time for your investments to recover after a market downturn. As long as you plan to buy and hold your investments, occasional downturns won’t change or destroy your portfolio.
3. Can I handle short-term loss?
We all know someone who practically loses when their portfolio drops in value. If that describes you, you’re probably not cut out for aggressive investing. Ask yourself three things:
Do I have a realistic view of how the market works, including profit and loss?
Will I be able to see the big picture when my portfolio’s value drops?
Does my sense of well-being depend on the performance of my investments?
4. Do I have an emergency fund?
Do you have money set aside in a rainy day fund, money you can use in an emergency? Now measure how much money you have in liquid accounts. If most of it is held in spot accounts, it could be a good sign that you are risk averse. If some of them are less liquid, your risk level can best be described as medium.
Charles Schwab offers an interesting way to spread investment risk. Divide your investments into “buckets”. Each bucket has a separate purpose. Funds intended for retirement support will be in a bucket. The resources invested to pay for one next vacation will be in another, and so on. It’s okay to invest every bucket, depending on how much time you have to recover from market dips.
For example, if you don’t plan on withdrawing for decades and have time to recover from losses, you might want to invest that bucket aggressively. A bucket designed to pay for once-in-a-lifetime vacations can be invested conservatively because you have less time to make up for a market downturn.
One of the first things a great broker will do is provide you with a questionnaire (paper or online), further narrowing your risk tolerance.
Investing is not an all-or-nothing proposition. Some of your investments will certainly benefit from being invested more aggressively, while investing others conservatively is a smart move (for you and your comfort level). It’s all about how much you’re willing to ride the cheap waves.