The portfolioPortfolio All the different investments that an individual or organization holds. May include stocks, bonds and mutual funds.+ read full definition that is right for you depends on many factors, including how much risk you can tolerate. The best portfolio for you also depends on factors such as your investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition objectives and investment time horizon.
The 2 sides of risk tolerance
You want your portfolio to be efficient – to have the highest average return, given the highest risk you are prepared to accept. If you have a low risk tolerance, you will likely choose a safer portfolio with a lower potential return. If you have a higher risk tolerance, you will likely choose a riskier portfolio with a higher potential return.
To understand your risk tolerance, answer these questions:
- How much risk are you able to handle?
- How much risk are you willing to handle?
Ability to tolerate risk
Your ability to tolerate risk – also called your financial risk tolerance – is your ability to handle an investment loss. If your investments carry enough risk that the loss would force you to reduce your standard of living you may be taking on too much.
Your ability to tolerate risk depends on your wealth. Wealth refers to both your financial wealth (investments and savings) and your human capitalHuman capital Human capital is someone’s ability to generate income from work.+ read full definition – your ability to generate income from work. This income can help you make up for investment losses. Wealthier investors can usually take on more financial risk. For example:
- A young, well-educated investor with no outstanding debtDebt Money that you have borrowed. You must repay the loan, with interest, by a set date.+ read full definition expects to work for 40 years before retiring. This investor has the time and human capital to make up for losses so she feels comfortable investing $10,000 in a higher-risk portfolio.
- A retired investor has a limited budgetBudget A monthly or yearly estimated plan for spending and saving. You work it out based on your income and expenses.+ read full definition each month for expenses. This investor cannot financially afford a loss of $10,000 without risking his monthly income to cover his expenses. He does not have the time or the human capital that the young investor has to recover losses.
Willingness to tolerate risk
Your willingness to tolerate risk – also called your psychological risk tolerance – introduces the emotional side of investing. If the level of investment risk in your portfolio causes you stress, you may have accepted more risk than you are willing to tolerate. To lessen your stress, you might consider making your portfolio less risky.
It is easy to overestimate your willingness to tolerate risk. Research shows that an investor’s stated belief in risk-taking is not the same as risk-taking behaviour. Behaviour is more influenced by past investment experience and beliefs about the future. Think about the last time you dealt with an investment loss – how did you react? If you had trouble accepting the loss, consider reducing the risk of your portfolio.
Set your portfolio’s risk at the lower of your ability and willingness to tolerate risk.
How your ability and willingness to tolerate risk connect
You should consider both elements of risk tolerance before you make an investing decision. For example:
A wealthy investor can afford to risk $10,000 investing in a start-up company. Even if the investment loses all of its value, this won’t affect her standard of living. However, if the idea of losing the money concerns her, she is better off not making the investment.
A retiree with modest savings who relies on a small pensionPension A steady income you get after you retire. Some pensions pay you a fixed amount for life. Others save up money for you while you are working. You use that money to create income after you retire.+ read full definition income is willing to take a risk on a $10,000 start-up investment. However, the loss of the money would mean he wouldn’t be able to maintain his current standard of living. He is unable to tolerate the loss financially so he should not make the investment.
Your risk tolerance is just one consideration when building your portfolio.
To understand your risk tolerance, consider both your ability and willingness to tolerate risk.