No matter what kind of investment you are making, there is always a degree of risk you are willing to take. Entrepreneurs are the best at assessing these risks, throwing their money and time, and ultimately making the big bucks from those otherwise risky investments. Personal risk tolerance is the amount of risk that an investor is comfortable taking or the degree of uncertainty that an investor is able to handle. Risk tolerance often varies with age, income, and financial goals. It can be determined by many methods, including questionnaires designed to reveal the level at which an investor can invest but still be able to sleep at night. The reward for taking on risk is the potential for a greater investment return. If you have a financial goal with a long time horizon, you may make more money by carefully investing in higher risk assets, such as stocks or bonds, than if limit yourself to less risky assets. On the other hand, lower risk cash investments may be appropriate for short-term financial goals.
An aggressive investor, or one with a high risk tolerance, is willing to risk losing money to get potentially better results. A conservative investor, or one with a low risk tolerance, favors investments that maintain his or her original investment.
Many investment websites offer free online questionnaires to help you assess your risk tolerance. Some of the websites will even estimate asset allocations based on responses to the questionnaires. While the suggested asset allocations may be a useful starting point, keep in mind that the results may be biased towards financial products or services sold by companies or individuals sponsoring the websites.
Risk Tolerance VS Risk Capacity
Risk tolerance involves a feature known as risk capacity, which identifies the amount of risk you can afford to take. This differs from the risk you are willing to take. For example, you may be comfortable with an aggressive, high-risk portfolio, but if you have only a few years to reach your investment goal, such as retirement, it may not be appropriate to have a portfolio of 100% stocks. In this case, you might be better served with a more conservative portfolio to preserve the investment assets you’ll need for retirement.
Main Points of Risk Capacity
- Risk capacity and risk tolerance work together to determine the amount of risk taken in an investor’s personal portfolio.
- Risk capacity often has to do with an investor’s income and financial resources.
- Risk tolerance usually depends on many factors, including one’s financial plans for the future, income, job, and age.
The problem many investors face is that their risk tolerance and risk capacity are not the same. When the amount of necessary risk exceeds the level the investor is comfortable taking, a shortfall most often will occur in terms of reaching future goals. On the other hand, when risk tolerance is higher than necessary, the undue risk may be taken by the individual. Investors such as these sometimes are referred to as risk lovers.
Taking the time to understand your personal risk situation may require self-discovery on your part, along with some financial planning. While attaining your personal and financial goals is possible, reason and judgment can be clouded when personal feelings are left unchecked. Therefore, working with a professional may be helpful.
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