Investing: 4 Ways to Determine Your Risk Tolerance

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  • Risk tolerance is broken down into three categories: aggressive, moderate, and conservative.
  • To determine which category best describes your risk tolerance, it pays to ask yourself a series of questions.
  • It's okay to mix-and-match by investing for some goals more aggressively than others.

Few things in life can be accurately described as one-size-fits-all. It's especially true for investing. 

We're all made of different stuff. Some of us loved climbing to the highest branch of the tree in the backyard, while others were happy to make it to the first branch (and then worry about how to get down). Some of us are risk-takers in life and investing. Some of us need a "sure thing." So, how do you determine where you fall on the investment spectrum? Are you a go-for-broke kind of investor, someone who plays it safe, or do you land somewhere in the middle?

Risk tolerance is broken down into three categories: aggressive, moderate, and conservative. If you're not quite sure where you fall, answering these four questions will give you a better idea.

1. What are my goals?

Ask yourself why you're investing. For example, do you want to:

  • Buy a home
  • Save for retirement
  • Retire 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 meet your goal(s) and get a sense of how aggressive you'll need to be to garner that amount of money.

2. What's my time frame?

Let's say you're saving to buy a home. You'd like to have a healthy down payment within three years. Generally, the less time you have, the less you can afford inevitable downturns in the market, and the more conservative your investments need to be.

On the other hand, if you're looking at a long-term goal, like paying for your child's education or retirement, you should be able to take on greater risk. That's because you have time for your investments to recover following a downturn in the market. As long as you plan to buy and hold your investments, occasional downturns won't make or break your portfolio.

3. Can I handle short-term loss?

We all know someone who practically loses it when their portfolio declines in value. If that describes you, you're probably not built for aggressive investing. Ask yourself three things:

  1. Do I have a realistic view of how the market works, including gains and losses?
  2. Will I be able to keep my eye on the big picture when my portfolio drops in value?
  3. Does my sense of well-being hinge on how well my investments perform?

4. Do I have an emergency fund?

Do you have money put aside in a rainy day fund, money you can use in an emergency situation? Now, measure how much money you have in liquid accounts. If most of it is kept in cash accounts, it may be a good indication that you're risk-averse. If some of it is less liquid, your risk level may best be described as moderate.

Charles Schwab offers an interesting way to spread investment risk. Divide your investments into "buckets." Each bucket has a separate goal. Funds earmarked to support you in retirement will be in one bucket. Funds invested to pay for an upcoming vacation will be in another, and so on. It's okay to invest each bucket based on how long you have to recover from dips in the market.

For example, if you don't plan to retire for decades and have time to rebound from losses, you may want to invest that bucket aggressively. The bucket intended to pay for a once-in-a-lifetime vacation might be invested conservatively since you have less time to make up for market downturns.

One of the first things a great broker will do is provide you with a questionnaire (either on paper or online), narrowing your risk tolerance down even more.

Investing is not an all-or-nothing proposition. Some of your investments will surely benefit by being more aggressively invested, while conservatively investing the others is the smart move (for you and your comfort level). It's all a matter of how willing you are to ride the economic waves. 

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