Determining your financial risk tolerance can help you find a comfortable path to financial independence. Your tolerance for risk includes your capacity to face risk without fear, but it can also take into account your current situation, your goals, and your time horizon. Risk tolerance is complicated but figuring out how much risk you can take on can help you make wise investment choices that won’t cause you undue stress over the years.
YOUR CURRENT SITUATION
Everyone’s financial situation is different, making it easier for some to take on greater risk because they can stand to lose more, while others can’t risk losing the little they have. For example, if your monthly expenses total $3,000 but you only have $1,000 in your bank account and you just lost your job. How much risk would you be willing to take on that $1,000? If you have absolutely no debt and have $100,000 in your bank account, with monthly expenses of $3,000 and a monthly income of $8,000, now how much risk would you be willing to take on $1,000?
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YOUR COMFORT LEVEL WITH RISK
How comfortable are you with risk? Here’s one way to think about it: Some people love roller coasters and get a thrill when they reach the peak and are about to fall, while others would rather watch safely from the ground below.
Regardless of your financial situation, if you’re terrified of losing any money and place your money in high-risk investments, you’re not going to get much sleep at night. Alternatively, if you’re not worried about short-term loss because you know things will bounce back in the end, you may feel like you’re not getting enough on your investment if you invest at too low a risk level.
Your comfort level with risk may change over time and as you become more experienced with investing, so it’s worth checking back in occasionally as time passes.
YOUR GOALS AND TIME HORIZON
Your goals and time horizon will also play a large part in how much risk you want to take with your money. Here’s what I mean:
Short-term goal (six months to four years)
A short-term time horizon can coincide with a lower risk tolerance. If you have a goal that will require funds between 6 months to a year from now, you may not be comfortable with a 20% drop in the market because it could deplete the money you were expecting to use right around the time when you need it most. So, if you’re planning to buy a house in a few years, taking the low-risk route may be best for those funds.
Mid-term goals (four to ten years)
Mid-range goals could include paying for a wedding, starting a business, etc. The list can go on and each person could have more than one goal that fits in this category. As the saying goes, time flies when you’re having fun. Snap your fingers and a decade has passed. Although this mid-range time frame seems short, you may be able to take a little more risk because you have time on your side. If the markets drop, they may have time to recover in time for you to recover the funds and your chances of getting a higher return are greater.
Long-term goals (ten to twenty years)
Retirement is the most common long-term goal. Suppose you are 40 years old and want to retire at age 65. Twenty-five years doesn’t seem like a long time, however it’s unlikely you’ll take all of your savings out the day you retire! We don’t come with an expiration date to predict when we are going to pass. Because of this I always say, “assume you will live until age 90 until someone tells you differently and plan accordingly.”
If you start saving for retirement at age 40 with the plan to retire at age 65 and do end up passing at age 90, you will be using funds that you saved for 50 years! 50 years provides a time horizon that allows for more risk to hopefully capture the best returns the market provides while being able to live through the market downswings.
CHOOSE YOUR RISK TOLERANCE
So, as you can see, determining your risk tolerance can be a little tricky. Fortunately, most advisors simplify the process by asking you some specific questions that are meant to figure out what your current situation is, how you feel about risk, and what your goals and time horizons are.
Click here to download a risk tolerance questionnaire that you can take at your leisure with your time horizons in mind. Once completed, reach out to a financial advisor to help guide you to financial independence.
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