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.
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