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Know our risk tolerance

Lesson in Course: Portfolio management (advanced, 9min)

Investing requires taking a risk, but how do we figure out how much we're willing to take?

Eureka!

What it's about: Our investment goal, time horizon, and financial circumstances influence our risk tolerance.

Why it's important: Risk tolerance helps determine our investment strategy and appropriate investments for reaching our goals.

Key takeaway: We can have different risk tolerances for different goals.

Risk isn't necessarily bad. It's only dangerous if we don't understand what it is and how it affects us. We might view risk as an exciting opportunity, throwing our hands in the air while riding the rollercoaster. Or, it could make us anxious, nervously gripping the safety straps. Understanding risk tolerance allows us to manage our emotional reactions to risk when making investment decisions. It also plays a critical role in forming an effective investment strategy.

Let's look at how various investment goals can have different risk tolerances and how that impacts our investment strategy.

Finding our risk tolerance

One way to think of investment risk, and our tolerance to it, as falling somewhere on a spectrum. On one end, conservative refers to the least risk, while aggressive is the most risk, and moderate is in the middle.

Risk tolerance scale

By following the steps below, we'll consider each of our investment goals individually. That way, we can implement the most effective strategy for reaching that particular goal.

Investment goal

Creating investment goals gives our investments a purpose and helps us make decisions, especially when we use the SMART framework. That purpose affects how much risk we can take. Potential losses for some significantly impact our lives more than others. 

Having realistic goals helps us succeed

For example, potential losses on investments made to pay for college or retirement would be life-changing. On the other hand, losses on assets used to pay for a vacation would have a minor impact. Therefore, we'd be more conservative about our investments as we approach retirement than a vacation goal. 

Step 1
  1. Start by listing out all of our goals and sorting them into nice-to-haves vs needs.
  2. Assign a number to each category. We'll assign 1 to needs, 2 to strong wants, and 3 to nice-to-haves.

Examples:

  • Needs (1): Retirement, welcoming first child
  • Strong wants (2): Pay for child's college, buy a house
  • Nice-to-haves (3): New car, trip to Mexico, new PlayStation or handbag, beach house
 

Time horizon

How much time we have to reach our goal affects how much risk we should take. Longer-term goals allow more wiggle room for the unexpected, while shorter time horizons require more predictability to maximize our chances of success. For example, aggressive investments work well when retirement is a long time away. It allows us to take more risk for higher returns because we have time to recover from any short-term losses.

Different goals will take longer to achieve

Shorter time horizons are more sensitive to losses. For instance, sudden drops in value because we were too aggressive hurt the odds of purchasing a home in a few years. Being more conservative in the short term means our investments will have lower growth but aren't likely to experience significant setbacks.

Step 2
  1. Take the list of goals in step 1 and reorganize them into short, medium, and long time horizons.
  2. Assign a number to each category. Short time horizons = 1, medium time horizons = 2, and long time horizons = 3.

Examples:

  • Short time horizon (1): Trip to Mexico, new PlayStation/Handbag
  • Medium time horizon (2): Buy a house, new car, welcoming your first child
  • Long time horizon (3): Retirement, Pay for kid's college, beach house
 

Financial starting point

While we might share similar long and short-term goals, not everyone is in the same financial situation. Our circumstances impact the amount of risk we should take. As we save more and earn a higher income, we can afford to be more aggressive. Investment losses are less impactful on our lifestyle if we have a higher net worth and our living expenses are less than our income.

Everyone's starting points depend also on family circumstances

While we want our investments to grow, being too aggressive without enough savings or income cushion could cause short-term losses that leave us in an unfortunate scenario of not making rent or covering emergency expenses.

Step 3

Looking at our credit card or bank statements, determine how much money we have to put towards our goals every month.

Examples:

  • Have $500 or less, write down a number of 1.
  • Have between $2000 and $500, write down a number of 2.
  • Have more than $2000, write down a number of 3.

Putting it all together

We arrive at an individual goal risk tolerance number between three and nine by combining our scores from all three steps above. 

Our risk tolerance can be quantified to help us set goals

A three represents the lowest risk tolerance, suggesting safer investment strategies such as bonds, target-date funds, or dividend stocks. A nine means very high-risk tolerance and could utilize speculative strategies such as stock options or alternatives like crypto.

Total risk tolerance
GoalStep 1Step 2 Step 3Total
Welcoming first child1225
Trip to Mexico3126
New Playstation / handbag3126
Buy a house2226
Retirement1326
New car3227
Paying for kid's college2327
Beach house3328

These numbers match the following spots on the risk tolerance scale and example investments:

3 — Very conservative — mostly cash and some bonds

4 — Conservative — some cash and mostly bonds

5 — Moderately conservative — a little cash, some bonds, a little stocks 

6 — Moderate — a little cash, some bonds, and some stocks

7 — Moderately aggressive — a little cash, a little bonds, some stocks

8 — Aggressive — minimal cash, mostly stocks

9 — Very aggressive — speculating with stock options and crypto

 

Actionable ideas

You can start forming appropriate investment strategies by listing our goals, prioritizing them, and defining risk tolerance. Some of your goals may end up sharing similar risk tolerances. Depending on the time horizon of the goals, some of these can be lumped together within the same strategy. As life situations change or new goals arise, it's essential to come back and update this list and reassess.

Supplementary materials

Check out this video for a quick review of risk tolerance
https://www.youtube.com/watch?v=mfeqH92z9Ic&ab_channel=InvestorTradingAcademy
Example Investor Profile Questionnaire
https://www.schwab.com/resource/investment-questionnaire

Glossary

What is Conservative?

Considered the low risk or least risky

What is Moderate?

Considered slightly risky, between conservative (least) and aggressive (most)

What is Aggressive?

Considered high risk or riskiest