Risk tolerance is the process of matching your investments to your temperament, lifestyle and financial goals. All investors want to earn a higher return, but to do so they must take on more risk. There are different types of risk, but generally your financial adviser will be talking to you about purchasing power risk and investment risk. Purchasing power risk is the risk that your money will lose its value due to inflation. Investment risk is the risk that your investments will decline in value.
Obtain a risk-profile questionnaire. Many are available online or from an investment professional, such as a financial adviser.
Complete the questionnaire. Usually, you will be asked about your age, how much variability in your investments' performance and value you can tolerate and how long your investment time horizon is. There is no right or wrong answer for any question. Each question is designed to help you learn about yourself and how you want to invest.
Using the scoring guide, determine your point score.
Using the explanation of your point score, read the questionnaire's description of you as an investor. See whether it fits. If not, look at your answers. Regardless, it is probably worth your while to do a second questionnaire.
With your profile and risk tolerance identified, start to research an asset allocation strategy, based on your financial goals. Decide how much to invest in stocks and how much in bonds and other fixed-income investments. Generally speaking, stocks provide a good hedge against inflation risk, but are subject to investment risk. High-quality bonds and other fixed-income investments, such as a bank deposits, protect you from investment risk but are subject to inflation risk.
A rule of thumb is that an average investor will be able to tolerate 100 minus his age as the percentage of his portfolio invested in the stock market. If you are 35, then 100 - 35 = 65, meaning 65 percent of your money should be invested in stocks. This is only a rule of thumb, however, so do a risk tolerance questionnaire before deciding on your strategy.
- Invesco Aim: Risk Tolerance Analysis
- Securities and Exchange Commission: Beginners' Guide to Asset Allocation, Diversification and Rebalancing
- U.S. Securities and Exchange Commission. "Assessing Your Risk Tolerance." Accessed July 27, 2020.
- Federal Reserve Bank of San Francisco. "In Times of Financial Stress, What Typically Happens to the Difference between Interest Rates on Corporate Bonds and U.S. Treasury Bonds?" Accessed July 27, 2020.
- U.S. Securities and Exchange Commission. "What Is Risk?" Accessed July 27, 2020.
- U.S. Securities and Exchange Commission. "Treasury Securities." Accessed July 27, 2020.
- U.S. Department of the Treasury. "Treasury Securities and Programs." Accessed July 27, 2020.
- U.S. Securities and Exchange Commission. "Asset Allocation." Accessed July 27, 2020.
- Morningstar. "Ratings and Risk." Accessed July 27, 2020.
- U.S. Securities and Exchange Commission. "Diversify Your Investments." Accessed July 27, 2020.
Jim Priebe has been writing and publishing since 1992, when he self-published the newsletter "Spiritually Speaking." His next assignment was with a small-town newspaper in which he authored the column "Environmentally Sound." Later he wrote Web content and maintained a blog for a community radio station. He holds a master's degree in economics from Queen's University and studied radio broadcasting at Humber College.