Risk Tolerance and its Impact on Investing
October 2, 2023 Author: Tess Downing, MBA, CFP®, Complete View Financial
Risk in finances is something that a lot of people have on their minds when going through financial changes and investment decisions. Being transparent and honest with yourself is crucial in identifying how much risk you and your financial state can handle.
There are two parts to the risk tolerance process. First, you must identify what you can psychologically handle regarding risk. Risk can be tricky, and you must create a level you can take without stress. Second, you must determine what you can handle based on your current financial status and position. While both of these aspects are important, they can have different levels as the answer, and it’s essential to consider both sides when determining your overall risk tolerance.
How to Avoid Risk: You Can’t
Overall, risk is unavoidable when making investment decisions. While you can choose to be less risky and make safer choices, all investments involve some level of risk. The whole point of investing is to take a chance on an item you think will give you a return.
Investors can assess risk based on the risk-free rate of return, which means that investors identify the value by investing in something, hypothetically speaking, with zero risk. Anything earned greater than this amount is considered a risk premium on a risky investment.
With this being said, risk and return are proportionate. The more you risk, the greater your return, and vice versa. However, with this greater return comes a higher chance of failure. Researching and identifying what investments are worth the risk and which aren’t is essential.
Different Types of Risks in Investing
Systemic Risk: This represents the risk outside anyone’s control and, therefore, can’t be eliminated; this includes macroeconomic factors such as a recession, depression, inflation, etc. Also, it can consist of factors such as tornadoes, fires, pandemics, and human factors such as terrorist attacks.
Unsystematic Risk: This is the risk specific to the different types of investments, which can change in the marketplace, litigation, poor management, and other potential investment problems.
Psychological Tolerance
Overall, you must know how much risk you can psychologically handle. Risk is a stressful topic. Be sure you’re comfortable with the amount of risk you are taking before you invest. The more risk-averse you are, the more conservative you are in your investing strategies. If you are willing to take on more risk, your approach is more aggressive. Whichever investor you are, ensure you’re comfortable in your investing decisions.
Risk Capacity
Risk capacity is the money you can lose or gain on a specific investment. It’s essential to calculate your time horizon, which is the time you have before you need to access the funds in your investment. With a longer time horizon, you have more time to recover from a potential loss. With a shorter time horizon, you must avoid significant losses and shift to more risk-averse investments.
The Hard Part About Risk Tolerance
A significant issue with identifying risk tolerance is the disconnect between risk capacity and psychological tolerance. These values rarely ever align. Someone whose psychological tolerance is higher than their risk capacity can make risky investments that end up putting them in a financial hole. The reverse is also true, as those with a lower psychological tolerance but a higher risk capacity can miss out on risky investments and significant returns that can help reach investment goals.
Whatever your risk tolerance, you must work with a financial advisor to ensure you are making the right investment decisions. Contact Complete View Financial today to learn how your investments impact your finances.