Erickson Financial Solutions Blog
1-minute video: What is your risk tolerance?
What is your risk tolerance?
All investments have risk and reward like a coin has two sides. Most people view only recent gains as a measure success of an investment choice to decide whether they should invest similarly again. But that is like Monday-morning quarterbacking in that the return received, after it has happened, is risk free. It does not consider the risk taken to get that return. Further, you can’t buy last year’s return.
So, looking prospectively, an investor needs to calibrate their appetite for risk against the potential reward. The percentage or amount you are willing to sacrifice if the investment goes badly is a measure of your risk tolerance. Every investment has its risks, but an investor should steer clear of those that exceed the loss they are willing to take to get the gain they seek.
However, in a well-diversified portfolio, an investor might buy investments that exceed their tolerance level if counterbalanced by safer, less risky investments. Modern Portfolio Theory is based combining differing risk levels, riskier than you would take if you only bought one investment, to create less risk overall. The result is greater returns for the amount of risk taken.
Risk tolerance varies depending upon your goals and the time horizon for when you need the money. Investing conservatively is likely the best route if the goal is important and soon to occur. However, for retirement savings, not only might it be years before you retire, you may be retired for decades and taking more risk is often necessary to insure you have the money you need when you need it.
The next time you evaluate whether to buy an investment, remember to review the return, but also how much risk was taken to get that return.