Investors know that one of the most important concepts to understand is that of risk tolerance. When you are making financial decisions — including investment decisions — you should know what you can handle in terms of risk. It is also important to realize that financial risk tolerance is not the only issue; you need to be aware of your emotional risk tolerance as well.
Financial Risk Tolerance
For the most part, financial risk tolerance is objective. It is mainly about the numbers. You look at your portfolio, and your money situation, and determine whether or not you can handle the risk involved. Financial risk tolerance also considers how much you can afford to lose.
- Can you afford to have $200 a month locked up in a retirement account?
- What would happen if you lost $1,000 investing?
Financial risk tolerance is different for everyone. For some, losing a few thousand dollars would not impact the long-term portfolio. Others, though, may not be able to even part with a couple hundred dollars. Before you make a decision, you need to assess your financial risk tolerance, taking into account the following factors:
- Whether you can comfortably afford the money you are considering.
- What would happen to your financial situation in a worst-case scenario.
- How long the money will be locked up, without you being able to access.
- How long you can do without the money.
- Whether or not you have a back up plan in place, or enough diversity to overcome a setback.
Once you have a clear picture of your finances, you can make a better decision based on your financial risk tolerance.
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Emotional Risk Tolerance
As much as we’d like to take emotion out of investing and other money decisions, it is practically impossible. We are influenced by our perception of risk, and we worry about what can happen in the future. The concerns can be magnified when money is involved. Understanding your emotional risk tolerance is almost as important as knowing about your financial risk tolerance.
If you are stressed about what is happening with a risky investment, it can affect other areas of your life. Concerns for money can stress relationships, and even affect your health. Even if you have the financial risk tolerance to handle an investment, if you cannot deal with the emotions that arise from the ups and downs of some investments and markets, it might not be worth it, in a non-monetary sense, to hold to the investment. If you will be constantly vexed by what might happen, it might be better to start with conservative investments and work up toward riskier investments. In some cases, those with a low emotional risk tolerance stick with more traditional and conservative investments, rather than moving on to those considered more risky.
In the end, before making investment decisions and other money decisions, it is a good idea to consider your risk tolerance — financial and emotional. Consider what your portfolio, and your stomach, can handle.