You frequently hear the word “risk” thrown around when it comes to the stock market, but have you truly grappled with the thought that you could lose everything? It’s easy to say that you are willing to take risks when things are good, when the markets are up, and when you are making continuous progress towards your goals. But what happens when the market cycle reverses and you find yourself losing money? Are you good with risk then?
In fancy financial talk, risk tolerance is defined as a measure of one’s financial ability to withstand losses. In other words, everyone will have their own risk tolerance level, based on their age, life circumstances, and time horizon. Unfortunately, it’s not as simple as telling your advisor you feel comfortable with “moderate” risk. So how can you determine your own personal ability to handle loss?
The Risk-Reward Continuum
The risk-reward continuum is the idea that the more risk you take, the greater your reward should be. If you are confident you can handle a 25% loss if the market goes south, you can invest more aggressively, potentially cashing in on higher returns than someone who is only willing to risk losing 10%.
When you think of financial risk, you probably think of people foolishly or extravagantly spending or investing their money. But as humans, we are more likely to make decisions to avoid future losses. This means that we are often more willing to take a risk to prevent a loss than to take a risk to obtain a gain in the future.1 It’s just as dangerous to invest at too low of a risk level as it is to invest at too high of a risk level as it might mean you don’t give yourself the chance to meet your goals.
Anticipate Your Limit For Risk
One thing I know is that you don’t want to figure out your risk tolerance accidentally. For example, you don’t want to go on an intense cycling trip through the mountains, reach the peak, and then be overcome with fear at the steep descent. At that point, it’s too late. You have to get down somehow. Similarly, you don’t want to get within 5 years of retirement and realize that you didn’t receive enough of a return on your investments to carry you through your retirement years.
Calculate different scenarios with different risk levels to get an idea of how much loss you are comfortable with. If you start to panic and cringe, then you know you’ve hit or passed your limit. Both positive and negative emotions frequently cause investors to make unwise decisions. If you’re excited about the upward swing of the market, you might throw caution to the wind and invest more money than you normally would. On the flip side, fear might drive you to react and sell if you start losing money.
By anticipating your limit for risk, you can simulate situations that cause those emotions so that you are prepared when they happen in real time. It’s a safeguard that will help keep you focused on the long-term and trust in your strategy.
What Factors Should I Consider?
Risk tolerance isn’t cut-and-dry. Here are a few factors that may help you determine how much risk you can handle:
- Time Horizon: How long do you have until you plan to retire? The further you are from retirement, the more risk you can take in order to gain more rewards.
- Investment Objectives: How much money are you hoping to save? The loftier the goal, the more risk you might have to take to reach it.
- Risk Capital: What is your net worth? If you have plenty of money available to invest and losing it won’t negatively impact your lifestyle, you can be more aggressive.
- Your Emotions: Even if the spreadsheets tell you that your financial situation can handle plenty of risk, how do you feel about that personally? Are you a more conservative person, favoring security and slow progress over exhilarating wins? Or do you love the thrill of ups and downs?
It Seems Complicated…
Determining your personal risk tolerance involves analyzing your financial situation and balancing it with what you hope to achieve. Sometimes it’s helpful to have an objective third-party help you lay it all out and walk you through different scenarios.
One of my roles as a financial advisor is to help my clients determine how much risk they are willing to take with their hard-earned money in exchange for potentially higher investment returns. It's my job to guide you toward a portfolio you can hold fast to when the road gets rough and real, or when permanent loss is staring you in the face. My goal is to help you discover your risk limits before you’re overcome with fear and tempted to panic. I’d love to chat with you, talk through your goals, and word towards your dreams while working within your personal risk level. Call my office at (949) 221-8105 x 2128, or email me at [email protected].
About Mike Loo
Mike Loo is an independent financial advisor with more than 20 years of experience in the financial services industry. His mission is to make a meaningful impact on the lives of clients and the people they care most about, help them make educated decisions with their money, and build a strong financial foundation for both themselves and their next generation. Mike is committed to meeting a high standard of excellence, taking the time to listen to clients’ needs, and designing strategies that aim to help clients save money and reduce debt. He seeks to fit a client’s investments into their life and educate them so they’ll understand their investments. To learn more about how Mike may be able to help, connect with him on LinkedIn, call his office at (949) 221-8105 x 2128, or email him at [email protected].
Mike Loo is a registered representative for LPL Financial. Securities offered through LPL Financial, Member FINRA/SPIC. Investment advice offered through Trilogy Capital Inc., a registered investment advisor. Trilogy Capital Inc. and Trilogy Financial are not affiliated with LPL Financial.