When determining tolerance for risk, the most important question to ask is: when will the investment returns will be needed? If the time horizon is relatively short, risk tolerance should be more conservative. For a long-term investment outlook, there is room for more aggressive investing, because investors have more time to recoup any possible losses and are therefore theoretically more tolerant of higher risks.
Net worth and available risk capital should be important considerations when determining risk tolerance. Net worth is simply your assets minus your liabilities. Risk capital is money available to invest or trade that will not affect your lifestyle if lost. Therefore, an investor or trader with a high net worth can assume more risk. The smaller the percentage of your overall net worth the investment or trade makes up, the more aggressive the risk tolerance can be.
Regrettably, those with little to no net worth or with limited risk capital are often drawn to riskier investments – like futures, options, or collectibles – because of the lure of quick, easy and large profits. This approach is dangerous because when too much risk is assumed with too little capital, an investor can be forced out of a position too early, resulting in a loss. By investing only money that you can afford to lose, or afford to have tied up for some period of time, you will not be pressured to sell off any investments because of panic or liquidity issues.
When it comes to determining an investor’s risk tolerance, the answer will vary based upon the age, investing experience, net worth, and risk capital of the investor, as well as by the actual investment being considered. Younger investors can take more risk because of the long-term strategies they are employing. Conversely, an older individual has a shorter investment horizon, and would have a much lower tolerance for risk.
It is important for investors to understand the idea of risk and how it applies to their investing portfolio. Making informed investment decisions entails not only researching investment reviews, but also having a deep understanding of one’s finances and risk profile.