A person’s appetite for financial risk—in other words how conservative or aggressive they are—is generally thought to correlate with the amount of return they have when investing. Of course, more risk doesn’t always mean more reward. In fact, the more effective application of risk appetite is in understanding your personal risk tolerance and how that should apply to your investment strategy—not the other way around. Understanding your appetite for risk is an important factor in making decisions about your portfolio, especially during times of change and volatility in the market.
There are many different approaches to assessing your appetite for risk, all which vary significantly from person-to-person. However, there are three factors that should be considered across the board:
Time Horizon: This metric looks at the amount of time your money will be invested. The shorter your horizon, the less likely the market has time to correct itself to allow you to recoup any potential losses. That means that for shorter-term commitments—for example, in the event that an investor is looking to withdraw the money for a large purchase in the near future—it’s generally smarter to go with more conservative investment strategies. A longer time horizon, on the other hand, is conducive to riskier or more aggressive investment strategies, because the market can go through multiple fluctuations before that money needs to be accessed.
Amount you have to risk: This is directly related to a person’s risk tolerance. Essentially, the more money you can afford to lose or, at the very least, tie up for a significant period of time, the higher your risk tolerance. It’s important to consider this in advance so that you avoid getting into a situation in which you have to sell off any stocks or investments, and get forced out of a position too early in order to have access to liquid funds.
The goal of the investment: What are your goals for your investments? This is a simple question that often gets overlooked. For many the goal is not to “beat the market” or raise as much money as possible. Some investors have a specific target in mind that correlates with a life goal, and targeting a specific return is often much more effective than trying to make the most money possible. Once you understand this, you may be better able to structure your investments with this knowledge in mind.
Of course, investors should also determine their personal comfort level with investing, as unrelated to the more tangible parameters of the time horizon and amount they have to risk. Even those with a relatively long time horizon and a significant amount to invest may find that they’re more comfortable doing so conservatively. In these instances, it becomes important to listen to your intuition because your relationship with your money is intensely personal. In considering your personal comfort, consider what keeps you up at night, and what you like or don’t like about your current financial situation. A proper assessment of your appetite for risk should take into account these very important factors, which are often a little more difficult to pin point.
As such, a good financial advisor or wealth manager will want a comprehensive account of your past investment experiences—what types of accounts you’ve held and what types of investing you’ve done. Your previous behaviors in these situations will help advisors work in partnership with you to determine the best approach moving forward. For example, many investors who are of retirement age are looking for conservative investment strategies based on their shorter time horizon, so they focus on more conservative strategies like fixed hybrid annuities and moderately positioned securities. A younger investor with a longer time horizon and greater income, may invest more aggressively—again, dependent on his or her goals and appetite for risk.
If you want to know more about your own appetite for risk, there are plenty of resources that can provide more insight into this area, such as, this Investment Risk Tolerance Quiz developed by Rutgers University, or another assessment developed by CNBC’s Money Control. However, the best approach is probably to work with a professional advisor or investment expert who can evaluate your appetite for risk in conjunction with an extensive understanding of the industry and market.
No matter what your risk appetite, the world of financial investing has changed a good deal over the last decade. This changes people’s relationship to money and as advisors we have to be cognizant of that, because it is ultimately what controls investors’ comfort level and their perception of their own success. A crucial piece of this involves understanding each client’s appetite for risk.