“To know thyself is the beginning of wisdom.” – Socrates
Risk tolerance is a measure of how much pain (loss, volatility, and negative news) investors can endure within their portfolio. Although every person is unique in their talents, their genetics, and their financial goals – when it comes to risk tolerance – most people fit into 3 camps:
Risk-averse: willing to accept a lower rate of return, so they can preserve capital.
Risk neutral: seeking to maximize expected value, and indifferent between a high risk event (e.g. lottery prize) or receiving $50,000 with certainty.
Risk-seeking: willing to accept greater market uncertainty in exchange for the potential of higher returns.
In order to grow and thrive during the long journey of investing, you need to follow Socrates’s advice and know yourself extremely well. There’s nothing more important about your investment “self” than your level risk tolerance. Are you a thrill-seeking gunslinger that will put it all on the line to strike it big? Or are you content with a more modest return that keeps your capital intact?
As you begin investing, think about the factors that will affect your own risk tolerance. They include your time horizon (age), earnings capacity, potential inheritance, and social welfare (i.e. pension & social security). Another huge component of your risk tolerance is your upbringing and your social environment.
Not sure about your risk tolerance? Take the “sleep test”… Can you sleep well at night while markets are tumbling? If so, stay on the path you’re on. If not, try tuning-down the risk level on your investment portfolio.
Just remember that, no matter what your risk tolerance is, you have a huge advantage as an individual investor over any “professional” investor. Unlike fund managers and professional traders that have to answer to their boss and disgruntled crowds of clients, you only have to answer to yourself! You can take your time and focus on long term results, rather than short-term quarterly earnings reports. This realization is especially valuable for younger individual investors, because they have a longer investment runway. They can afford to be more aggressive with their allocations, wait-out wild market swings, and allow for market downturns to turn into bull markets. On the other hand, older investors need to be more conscious of the risk-reward trade-off as they get closer to retirement.