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What is Risk Tolerance?

by Invisor Last updated on February 08, 2017 Tags: Save Well

Risk plays a big part in your investment plan. Whether you opt for a more conservative route, or prefer a high-risk, high-growth approach, understanding how risk fits into your portfolio is essential in creating a plan that works for your goals.

What is the difference between good and bad risk?

When it comes to investing, there’s a common notion that all risk is bad. But there are good risks that can help you succeed in achieving your financial goals.

It’s good to take risk when you know (more or less) what the outcome will be and, if doesn’t happen, you would be okay with the consequences. It involves thinking about the pros/cons and reaching out to an advisor when you need more information.

Bad risk, on the other hand, happens when it’s very likely that the expected outcome won’t happen, and you would have to endure significant negative consequences.  

Why is risk important in my portfolio?

“You invest to earn a return on your money...Risk and return are connected. Generally, the higher the risk of an investment, the higher the potential return.” – getsmartaboutmoney.ca

When we take on higher risk we expect a higher return, because investors need an incentive for taking on that risk. Some investments, like stocks (equities), contain higher risk. We expect riskier assets to fluctuate more, but we also expect them to return better over time. This means that a portfolio with a higher risk tolerance will have more exposure to higher risk equities than those without. On the other hand, something with little risk, like a GIC, won’t fluctuate, but will barely keep up with inflation.

When it comes to your portfolio the amount of risk you should take depends on your overall appetite for risk, and your ability to take risk.

What is risk appetite?

Risk appetite is your approach to how you view risk. Are you a risk avoider, willing to take calculated risks, or more of a gambler? These questions will help you figure out how comfortable you are with fluctuations in your account, and how you’ll react to swings in the value of your portfolio.

What is my ability to take risk?

Risk tolerance is a combination of your willingness to take risk, and your ability to take it. This is determined by your overall situation and goals.

When it comes to your situation, the stability of your income and career will determine if you can take financial risks. The more stability and safety net you have (both financially and overtime) to cover unexpected risks, the more risk you’ll be able to take in your portfolio.

Your goal and the time you have to reach it will also impact the amount of risk you’re able to take. For example, you may have an aggressive risk tolerance, but high risk won’t be appropriate for your goal of buying a house in three years. Short-term goals like this will lower your ability to take risk, because you don’t want to risk the money you’ve saved up. However, long-term goals like your retirement that might be 35 years away, can afford more risk. Year-to-year fluctuation in the short-term doesn’t matter as much when you’ll be keeping your investments locked away for 25-30 years.

How can I manage risk?

  1. Long-term investing might not be as risky as it seems. Even with short-term volatility, equity markets have done well over long periods of time.
  2. Be comfortable with the worst-case scenario. In 2008, several equity markets were down more than 30%. If that happened again, how would you feel?
  3. Holding a diversified portfolio ensures you're not exposed to one specific market event or company performance. 
  4. Have an investment plan so you can rebalance your portfolio and keep your emotions away from your decisions. 
  5. If you're not sure how much risk you should take in your portfolio, work with an advisor who can help point you in the right direction.

Risk is an important part of investing because with it, it brings return. If you didn’t take any risk, your investments likely wouldn’t grow enough to meet your goals. Sometimes, the biggest risk is not taking enough of it.

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