How Much Investment Risk Can I Handle?

Determining risk tolerance should be one of the first parts of an investing and asset allocation strategy. Without an understanding of the level of risk you can tolerate, it is difficult to know if you are building a portfolio that is consistent with your financial goals. Most investment advisors seek first to classify a new client by risk profile and then use an asset allocation model that corresponds with that profile. Risk tolerance is a relative thing, but the more investment risk you are willing to take on, the higher your expected investment returns are likely to be.

Investment risk simply refers to the possibility that the return on an investment will be lower than expected; including the possibility of losing all of the original investment. However, because investors need to be compensated for taking on higher levels of risk, they should expect greater potential returns from their riskier investments.

The primary elements of risk for any particular investment might include:

Business risk: The potential for an investment to decline in value due to increased competition, bad business management or unforeseen changes in market conditions.

Valuation risk: The potential for an investment to lose value because the purchase price exceeded its intrinsic value.

Force of sale risk: As an investor, you cannot always know when a security will increase in value. Given that, you need to make sure you build in a satisfactory time horizon to hold the investment.

The level of risk an investor is willing to tolerate can depend on a number of factors, including:

Personality: It is critical for investors to know themselves well enough to predict how well they can tolerate market fluctuations and the emotional toll they can take. Even investors with long-term horizons can struggle with (often temporary) declines in portfolio values.

Time Horizon: Generally speaking, investors with longer time horizons can take on higher levels of risk than those who are hoping to retire in the next few years. Investors who are working with longer timeframes have more of a chance to recover from financial setbacks.

Financial position: Investors who are working from strong financial positions may be better suited to take on higher levels of risk since they have greater resources to fall back on if things do not go as well as expected.

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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.

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