You probably know that investing involves risk. Different investment products and strategies involve different degrees of risk. Generally, the higher the expected returns of a product or strategy, the greater the risk that you could lose most or all of your investment.
So what level of risk is too much? This isn't a simple question, and there's no "right" answer.
It all depends on your risk tolerance--the amount of investment risk you're willing and able to accept--which is impacted by a variety of factors and is unique to you.
Risk Tolerance Factors
Here are four factors to consider when evaluating your risk tolerance level:
- Investment Objectives: What are your objectives for this account? Investments that have the potential for significant growth also come with a higher risk of significant losses. On the other hand, if your objective is preservation of capital or protecting the assets in your portfolio, you might choose investments that involve lower risk but that also might not result in the growth or income you require. Your investment objective should reflect your needs and desired outcome, as well as the risks you're willing and able to take to meet your goals.
- Investment Time Horizon: If you're looking at a long-term investment--for example, if you're in your 20s and planning for retirement--you can probably afford to take on more risk. You have decades to make up for losses your account might sustain. If your timeline is short, however, you likely don't want to risk your account value seeing a significant decrease just as it's time for you to withdraw. You might want to consider the liquidity of your investments in tandem with when you expect to need funds.
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Reliance Upon the Invested Funds: Are you counting on this money to provide you with essential funds, either now or in the future? For example, is this the main source of money for a home down payment or your child's college education? Or is this disposable income that won't really impact your lifestyle if you take losses?
When assessing whether this really is money you can truly afford to lose, consider your financial circumstances and needs--not only what you earn and your overall net worth, but also your short- and long-term spending requirements. This might include:
- routine expenses (e.g., housing, food, transportation, utilities, child care);
- periodic or emergency expenses (e.g., home or car repair, medical care); and/or
- potential long-term expenses (e.g., buying a car or house, paying for college, paying for long-term care).
As you assess how best to generate the returns needed to meet your goals, keep in mind how dependent you are on these funds, in addition to where you are in your investment timeline, and choose your investments and investing strategy accordingly. - Inherent Personality: You probably have some idea as to whether you're generally a cautious person or more of a risk-taker. The amount of risk you can technically afford to take isn't necessarily the same as the amount of risk you're comfortable taking. You don't want this to outweigh logic in your investment decisions, but it's something to consider. If the idea of losing money makes you squeamish, you probably don't want to pick the highest risk investments--you might be more likely to back out early if you face volatility, which could also mean missing out on the potential profits.
Why Risk Tolerance Matters
Once you know your risk tolerance, you can use that to inform your investing decisions. Investments should be chosen based on your objectives, needs, time horizon and tolerance for market changes.
Remember, your risk tolerance is personal. It's important to make decisions that are right for you, not for a friend, family member or social media influencer--even if you trust their advice. If you're working with a financial professional, clearly communicate your risk tolerance to them.
Even if you feel comfortable taking on a significant amount of risk, you should still be thoughtful about your investment decisions and how they fit with your financial profile. Being willing and able to take on a certain amount of risk are two different things. Make sure the risk you're willing to take is consistent with the level of risk you're actually able to take.
Never invest in an investment product you don't fully understand, including what risks are involved. And be aware that guaranteed investment returns, high pressure sales tactics and promises of low risk can be hallmarks of investment fraud.
Though it doesn't ensure a profit or guarantee against loss, diversifying your portfolio is a smart strategy to manage your risk exposure no matter what your risk tolerance is. To diversify your portfolio, you'll want to select investment products from different asset classes (e.g., stocks and bonds) as well as different types of investments within those asset classes (e.g., stocks of companies from different sizes or industries or broad-based index funds).
Then you'll want to make sure that your portfolio evolves along with your circumstances. Check in with your assets--and yourself--periodically to confirm whether the two are still aligned. You'll likely want to rebalance your portfolio and adjust your strategy over time.
While there's no such thing as a risk-free investment, paying attention to your risk tolerance can help you make investment decisions based on the risk level that's right for you.
Learn more about investing basics.
