Understanding Your Risk Tolerance

You'll make better investing decisions if you understand your risk tolerance.

“Know thyself” is one of the great admonitions of all time. Before you start investing, it's a good idea to take a look at yourself, and understand the level of risk you can handle. Once you understand your risk tolerance, you'll make better investing decisions — including knowing when to leave well enough alone.

Financial Risk Tolerance

First, assess your financial risk tolerance. This is all about the numbers. How much risk can your financial situation handle? Basically, you ask yourself how much you can afford to lose.

If you have extra money sitting around, you might be able to play with a riskier asset, since it might not matter if you lose your capital. However, if you don't have a lot of money to lose, and if you have a set amount that you invest regularly, stick to the less complex investments, and use dollar cost averaging to help you build wealth over time.

When considering an investment, it also makes sense to look at how long the money will be tied up. It's usually a good idea to invest for the long term with the help of a tax-advantaged retirement account, but you have to realize that the money you use this way is going to be less accessible to you for a set period of time. If you are trying to build up a nest egg, this is actually a good thing; you will be less tempted to withdraw the money. Just make sure that your efforts don't put your current finances in jeopardy.

Keep the financial realities of your situation in mind as you create an investment plan, and be careful not to get involved with investments that you don't understand, and don't use money that you can't afford to have locked up for a long period of time, or that you can't afford to lose.

Emotional Risk Tolerance

Another aspect of your ability to handle risk has to do with your emotional state when it comes to investing. Even if you have money that you can afford to lose, you don't want to take a chance if you can't stomach the level of risk involved.

Your emotional risk tolerance deals with how jumpy you are about an investment. Understanding your emotional risk tolerance can help you overcome some of the pitfalls of your own investment style. Fear and enthusiasm are two sides of the emotional risk tolerance coin, and you need to know how to manage these emotions:

1. Low emotional risk tolerance is represented by fear. You might be afraid to take any calculated risk, and stick primarily with cash and Treasuries. While your capital is likely to be preserved, you probably won't see the returns that help you build adequate wealth.
   
2. High emotional risk tolerance leads to enthusiasm about investments. You might be energized by risk, and this can mean ill-advised investments that are beyond your financial risk tolerance. While these types of risks can pay off big, they can also lose big — and cause problems.

Understand your tendencies, and then work to moderate them. Consider adding low-cost funds to your portfolio in order to counter both of those tendencies. You can add better returns to a too-conservative portfolio, or add a little sanity to a portfolio that has too much risk. They are great middle-of-the-road investments.

Bottom Line

When you know your investing style, and when you are honest about your shortcomings, it's easier to see your way forward. You should also look at your total risk tolerance, including the financial and emotional aspects. When you understand yourself, you can create an investment plan that emphasizes your strengths and shores up your weaknesses.