Risk Tolerance: Know Thyself
Your risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns.
Two Components of Risk
- Financial Ability: Can you afford to lose this money? If you need the cash for a down payment in 2 years, you have low risk capacity. If you are saving for retirement in 30 years, you have high capacity.
- Emotional Willingness: How will you react if the market drops 30%? If you panic and sell, you have low risk tolerance.
Determining Your Profile
- Conservative: Preservation of capital is priority #1. You accept lower returns for peace of mind.
- Moderate: A balance of growth and safety.
- Aggressive: Maximum growth is the goal. You can stomach large swings in value.
The Sleep Test
If your investments are keeping you up at night worrying, you are taking on too much risk. Dial it back until you can sleep soundly.
If your investments are keeping you up at night worrying, you are taking on too much risk. Dial it back until you can sleep soundly.
Real Life Examples
Mrs. Williams
Teacher . $60k . 20% Savings
Moderate-Aggressive. She understands she won't need the money for 30 years. She holds 90% stocks and ignores the daily news. She sees market drops as a "sale."
Mr. Johnson
Average Joe . $90k . 10% Savings
Conservative. He is afraid of losing money, so he keeps 50% in cash. He feels safe, but inflation is quietly eating away 3% of his wealth every single year.
Mr. Smith
Mr. Popular . $120k . 5% Savings
Confused. He is aggressive when the market is up ("I'm a genius!") but becomes conservative when it crashes ("Sell everything!"). This buy-high, sell-low strategy destroys his wealth.
Assess your own risk tolerance with these tools:
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