Risk Tolerance: 3 Primary Aspects

When creating an investing strategy, you need to remember to consider your risk tolerance.?

If you want to succeed at investing, you need to make an investment plan.

The first thing you need to do as you develop your investing strategy is understand your risk tolerance.

Knowing your risk tolerance provides you with an understanding of yourself and your situation. Once you have a solid idea of where you stand, and how much risk your situation can handle (or how much it needs), you can create an investment strategy that works for you.

Recently, I received an interesting white paper from FinaMetrica that takes a look at risk tolerance. This white paper takes a look at risk profiling, including what FinaMetrica purports to be the three primary aspects of risk.

3 Primary Aspects of Risk Tolerance

As you consider your own risk tolerance, it makes sense to consider the aspects of risk set forth by FinaMetrica's white paper titled, “Risk Profiling: Art and Science”:

Risk Required

This is the amount of risk your portfolio requires in order for you to meet your investing goal. If you are trying to amass a larger amount of wealth in a shorter period of time, your risk required is going to be greater. If you have more time to develop your nest egg, you won't need as much risk in your portfolio to reach your goals.

Risk Capacity

This is basically your ability to cope with loss. The white paper describes it as “the extent to which the future can be less favorable than anticipated without derailing the client's plans.” Can you, financially, handle some of the setbacks that come with investing?

Risk Tolerance

In the FinaMetrica model, this is how much risk you prefer to take. It doesn't have much to do with your financial situation. This is a psychological factor that deals with your comfort level with the risk you are taking.

Bottom Line

In order to figure out how to best construct your investing portfolio, you need to understand these aspects of risk and know where you fit in.

You might have to consider adjusting some of your plans and expectations. This will help you understand the realities related to your risk situation. Even if you think you need to be aggressive in order to reach your retirement goals, you might not actually be able to handle the required risk. Your risk capacity might not be high enough.

Each of these aspects of risk interacts with the others, and by balancing them out, you can find a mix of risk for your portfolio that can offer you the best chance of success.

What do you think of this description of risk tolerance? How do you use risk tolerance to create your own investing portfolio?

3 thoughts on “Risk Tolerance: 3 Primary Aspects”

  1. Retail investors should always judge the smart money’s sentiment before making an investment decision. Excellent article Miranda.

  2. What gets tricky is individuals’ risk tolerance changes as markets change.

    When markets are soaring, investors overestimate their capacity to take on risk because the potential downside seems so theoretical.

    After a market collapse when investors potentially should take on more risk, they are running scared.

    My primary method for assessing risk is the ability to withstand capital loss without having to make major life changes – either day-to-day living expenses or future retirement plans.

    1. Miranda Marquit

      That’s a good point. Investors need to be on top of changing risk tolerance, as well as do their best to overcome emotional reactions to what’s happening in the markets.

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