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5 Steps to Determining Your Risk Tolerance Thumbnail

5 Steps to Determining Your Risk Tolerance

There is a degree of risk in any financial investment. How comfortable you are with this statement may give you a clue as to your risk tolerance. You can think of risk tolerance not only as how much you are willing to lose on your investments but rather how much uncertainty you can live with from day to day. Are you the type to sit and watching to stock ticker pass by all day? If so, does it fill you with dread or excitement? Or do you wish to have an asset manager do it with you? These are the kinds of questions you should be asking yourself. The answers will, in turn, help you pick out an investment portfolio that is right for you.

1. Know Yourself 

You should not ignore the individual identity component of the risk tolerance assessment. Some of your risk tolerance can be measured, meaning that the amount of risk you can tolerate is based on factors like your age or your income. However, you may dislike making risky investments. That is okay. It always helps to know how comfortable you are with spending—or not spending—your money the way you like. Finance professionals are there to help you fulfill your goals. Therefore, understanding how you want to handle finances is key to achieving your goals and will help the wealth managers you work with to accomplish them with you.

2. What are Your Financial Goals?

Do you save money to accumulate wealth, or are you looking for ways to retire early? For example, suppose your only goal is to have a nice pile of money to retire on when you are seventy years old. In that case, your strategy will be different from investors that are more aggressive. In this case, you are looking to have a steady accumulation over time that will be enough for a happy retirement. On the other hand, if you want to retire while you are relatively young, you are looking for investments with a high risk to reward ratio. In this instance, you are willing to deal with higher levels of volatility if it can get you to the finish line faster.

These retirement-focused goals are not the only goals that can impact your investment strategy. For example, you may be saving to buy a house or considering purchasing/starting a business.

3. What is your Time Horizon?

If you are relatively young, you have plenty of time to ride out the peaks and valleys of the economy. Therefore, you can tolerate a riskier strategy than a person who is five to ten years from retiring. On the other hand, if you have a goal you need to meet quickly, like buying a home or nearing retirement, you may want to think more conservatively to preserve your wealth. It is always important to remember that stable wealth is built over time. Understanding your time horizon is essential as you build your wealth. Your strategy may need to change as your time horizon changes. Time horizon is a good thing to keep in mind as it allows better perspective into the day-to-day changes that occur when investing..

4. Personal  Wealth and Income

If you have $5 million to invest, you can take more chances than you should if you have $50,000. That is relatively straightforward. You may also consider additional factors, such as the amount of debt you are carrying or whether your ecosystem (job, family, assets, etc.) is solid and stable. Asking yourself what expenses will need to be covered in the short term and long term will help guide you in what can be invested and how much liquidity--the ability to quickly be in cash--the investment needs to have to cover these cost.  

5. Get Good Advice

Working with an asset manager or a wealth manager can help reveal your risk tolerance and map out a strategy. You can prepare yourself for the discussion by looking at one of the many online questionnaires to help you look at yourself. You can ask some of the more apparent questions yourself, such as, what would you do if presented with $250,000 to invest. How can you use this money the way you want to now or in the future? Is the money needed in the short-term for expenses, or is it an opportunity to build wealth that will allow you to enjoy retirement or pass on to your children at some point?

Even after you have asked yourself the tough questions, you may still want to talk about risk tolerance and risk appetite with an experienced wealth manager. You may find that you are not as risk-averse or risk tolerance as you thought. As a result, you can learn about yourself and make better decisions regarding your future.

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