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Assessing Your Risk Tolerance

Perhaps the biggest risk of investing is not investing at all. Before you are ready to enter the market, you must first define the type of investor you are by looking at your goals and the risks you are willing to take to achieve them.

Investing your money can be a difficult process, especially with all of the different choices that are offered today. Choosing the right investment vehicle for your needs can be a tough task and, in doing so, one of the questions you should ask yourself is, "What is my risk tolerance?" Risk tolerance is your ability to handle potential declines in the value of your portfolio. Risk should be your primary concern when investing, as accepting risk separates savers from investors. It is widely believed that an individual's tolerance for risk is developed early in life, and is a characteristic that is not likely to change. To better understand what your risk tolerance is, there are several steps you should go through.

Defining Financial Goals

The driving force in choosing your investments should be how you want your money to grow. Your financial plans may range from such long-term goals as saving for retirement, to a short-term savings plan for a vacation in the upcoming months. Both of these are good reasons for saving and investing. When determining where to invest your money, you should take the time to figure out the investment strategy that will best suit your goals.

Another important factor in defining your financial goals is determining the timeframe in which they are to be reached. This is critical because different time horizons require different investing strategies. If you are going to need your money relatively soon, it should be invested in safe and accessible accounts. On the other hand, if you are investing for a time period much farther down the road, you will not need to worry about the day-to-day fluctuations in the value of your investment, but rather focus on the goal of earning a high return over time.

Understanding Risk

After you have established the goals of your investment strategy, you must determine your investing comfort zone, or ability to withstand market fluctuations. An investor's ability to handle risks may be related to certain characteristics, such as age, liquidity needs, portfolio size, and income. One of the factors used in determining your risk tolerance is the size of your non-investment income. As the size of non-investment income grows, so does an investor's likelihood to be more risk tolerant. This is because a larger non-investment income allows the investor to maintain his/her lifestyle in the short run, regardless of market fluctuations. Another factor dealing with the investor's tendency to take risks is the amount of assets they hold. There is a direct correlation between the amount of money held and the investor's risk tolerance. As your financial assets grow, you may become more willing to take larger risks with your money. An additional factor in determining risk tolerance is the number of years to retirement. The farther from retirement you are, the more likely you will be to take higher risks, as over time the risk associated with long-term investments decreases as the market continues to increase.

In general, those households holding sufficient financial assets for short-term goals tend to be much more willing to take risks than a household without sufficient assets. Likewise, investors who are far from retirement and have a high non-investment income should also be willing to take more risks when considering their investment strategies.

Types of Risk

For one to better assess risk tolerance, it would be beneficial to understand some of the different sources of risk. One source of risk is called business risk. Business risk usually correlates with the type of investment you are making. If you are to invest in a small start-up corporation because of the potentially higher returns that are offered, you are leaving yourself open to the fact that the company may fail, rendering your investment worthless. This type of risk is not commonly associated with more established blue-chip stocks, as their likelihood of failure is much smaller. Another type of risk is market risk. Market risk is always a concern as a stock's price may be affected by broad market trends. A typically strong stock may decline in value simply because the market has entered a down cycle. The best way to combat market risk is through diversification, a process by which the investor holds different types of assets, as markets do not all move in the same direction at the same time. A further source of risk may be political. Governments at all levels have a tremendous impact on the investment climate, and their attitude on business or capital sets the stage for either success or failure of an economy. A government may impose a political action, such as raising taxes to declaring war, which may harm the economic climate.

Types of Investors

Now that you are able to determine your risk tolerance, you can assess what type of investor you are:

  • Very Conservative Investors: Likely to feel at ease with investments that are less likely to fluctuate in volatile markets. This strategy may not offer the highest rewards, but is useful for those approaching retirement, and for those who plan to spend more than they will earn in the short run.

  • Conservative Investors: Tend to prefer a cautious approach to investing that takes only prudent risks in seeking a reasonable return. These investors are more comfortable with the peace of mind that comes with a more stable portfolio.

  • Moderate Investors: Prefer a diversified mix of investments, including some conservative holdings to offset some riskier ones. A moderate investor is more likely to feel comfortable with a balance of asset classes, both domestic and abroad, along with the diversification found in a combination of stock and bond holdings.

  • Aggressive Investors: Are more apt to have a bold investment approach in which higher risks are taken in return for potentially higher returns. This strategy should be employed by investors with long-term goals, such as children's education or retirement.

  • Very Aggressive Investors: Willing to take a significant amount of risk in return for potentially higher returns. This strategy is best suited for the young investor who doesn't plan on spending investment earnings soon.

Each of these types of investors have different strategies. The following is an example of what their portfolio may look like:

    Percentage of Portfolio by Investment Type

(Moderate Risk)

(Low Risk)

Equity Income Fund
(Low Risk)

Growth Fund
(High Risk)

International Growth Fund
(High Risk)

Very Conservative
























Very Aggressive






Now that you know how to assess your tolerance for risk and some different investing strategies, what are you waiting for? The longer you go without investing, the longer you will go without the benefits. There are some key points to remember in investment strategy, though. The most important of these is diversification. Through the process of diversification, a majority of the risk associated with investing is eliminated. Overall, market risk tends to be a short-term phenomenon, which falls over time, and the biggest risk that you may take is not being part of the market at all.

For more information, read the Federal Reserve Bank of Dallas publication Building Wealth: A Beginner's Guide to Securing Your Financial Future. Visit the CareOne Credit Knowledge Center Library to find other articles related to investing.

Take control of your finances with our debt help tools. Use our calculators and budget planner to help you manage your money.

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