When it comes to investing there are several industry words and phrases that get used and are often assumed to be understood by the investors. Understanding these words and phrases is not always an intuitive thing for all people. So today, we’re going to discuss Risk Tolerance and what it really means.
According to Investopedia, by definition, “Risk Tolerance is the degree of variability in investment returns that an investor is willing to withstand in their financial planning.” Do you understand all that or did you hear Charlie Brown’s teacher saying, “wah, wah, wah?” To many, it’s the second item they hear. So, let’s break it down.
In layman’s terms, Risk Tolerance is how much you can stomach the up and down values of your investment accounts as the stock market moves. When you look at your investment account values and see them going down, at what point do you feel like you want to sell and get out of the stock market? That point is what risk tolerance measures. It measures how much “loss” can you withstand in your investment account. “Loss” is in quotes because while your account is invested, the values are only fluctuating, and they fluctuate throughout the day, minute by minute. A loss is not actually incurred until you sell your investment position at a price lower than the price you originally paid for it.
You may be wondering, what about when the account values go up? How does risk tolerance play a role here? Great question. When an account value is going up, there is typically not a single person who wishes to cap the upward growth, so the growth then becomes a variable in the risk tolerance measurement. This is because with greater upward growth potential comes the greater downward loss potential. They are relational. The more volatile an investment position is, meaning how often it changes, fluctuates, and moves, the more growth potential it has, but it can move greatly in both directions, both up and down.
To maximize the growth of an account, then the maximum risk is often taken, meaning the investor would also be putting himself in a position to see the potential for both a significant amount of growth and loss. This would be an aggressive type of Risk Tolerance.
To see growth of an account and only a moderate amount of loss, the investor would be willingly setting aside a portion his growth potential to limit the amount of loss in his account value. This would be a moderate type of Risk Tolerance.
To see a little bit of growth of an account and to limit the amount of loss to bare minimums, the investor would be willingly setting aside almost all the growth potential to conserve the account value and experience only a minuscule amount of loss. This would be a conservative type of Risk Tolerance.
So how do you know what your Risk Tolerance is? There are questionnaires financial planner use to help measure your risk. We use a tool called Riskalyze that will give you a score from 1-99 based on your answers. The higher the score, the more aggressive you are. The lower the score, the more conservative you are. Using Riskalyze, you can measure your own Risk Tolerance here. Knowing your risk is important when it comes to investing in the right type of vehicles. It’s just one of the many factors that help financial planners like us make the best recommendations for your investment portfolio.
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Financial Planning and Investment Advisory offered by SWMG, LLC a Registered Investment Advisor. Investing involves the risk of loss, including loss of principal. Past performance does not guarantee future results. Investment products are not FDIC insured, have no bank guarantee, and may gain or lose value. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be profitable for a client’s investment portfolio.