Lesson 2: How risk tolerance should influence your investment choices
Consider your time horizon and how you react when your portfolio value fluctuates to estimate your risk tolerance.
CIBC Investor’s Edge
6-minute read
When you’re deciding what to invest in, it’s important to consider how long you plan to keep this money invested and what it will eventually be used for. These factors primarily determine your risk tolerance — your ability and willingness to endure fluctuations in the value of your investments.
If you need a certain amount of money by a specific date, especially in the near future, this will influence your investment choices. Most investments fluctuate in price, but some tend to fluctuate more than others. You want to ensure that your money won’t be decreasing in value close to the time you need to spend it. How much fluctuation you can tolerate while still maintaining your investment strategy, meeting your goals and keeping your cool, is known as risk tolerance.
The volatility of risky versus conservative investments
How much the price of an investment fluctuates, also called its “volatility,” is one characteristic that helps distinguish risky from conservative investments. An investment is often called “risky” when its price fluctuates a lot and “conservative” when its price fluctuates little.
Why would an investor buy a risky asset? Because there’s a greater chance that investment will produce an above-average return over the long term.
Here’s an example. Compare the stock of a start-up technology company to the stock of a well-established consumer products company that’s been around for 50 years. The price of the start-up stock will likely fluctuate more day to day and month to month. However, the start-up has much greater future growth potential when compared to the consumer stock, which will likely just match the growth rate of the overall economy. Since a company’s growth rate is closely tied to its return over the long term, riskier investments have the potential to produce a higher return, especially if you hold them for a long period of time.
What are examples of low, medium and high-risk investments?
Low-risk investments include government bonds and savings accounts, which offer stability and lower returns.
Medium-risk investments include high-grade corporate bonds, dividend-paying stocks, and stocks of established companies that don't pay dividends. Stocks can be classified as medium to high risk depending on the type of company. Medium-risk stocks are typically those of well-established companies with stable earnings, while higher-risk stocks may include those of companies in volatile sectors or with uncertain growth prospects. The highest-risk stocks are often those of startups or smaller companies, which have high growth potential but also significant uncertainty and volatility.
High-risk investments, such as stocks of startup companies, cryptocurrencies and venture capital, offer higher potential returns but come with significant volatility and risk.
While riskier investments have more growth potential, neither higher growth nor a higher return is guaranteed. Investments in risky assets can sometimes result in large losses.
Your time horizon guides how much risk you should take
Your time horizon — another way of saying when you’ll want or need to spend the money you’re investing — is a very important consideration.
Consider a goal with a long time horizon, saving for retirement for example. Riskier assets, with their potential for higher returns, make sense — you have more time to sit through market ups and downs. With a shorter time horizon, maybe saving to buy a car by a specific date, you’ll probably want to be more conservative. You want to be as certain as possible that the amount you need will be available by your target date, especially if that’s soon.
Your time horizon helps you figure out the right balance of risk and potential reward when you select among different investments.
An example: Let's say you'd like to retire in 25 years, and you've determined you need about an 8% annual return on your investments to meet that goal. When you look at very low-risk options, like guaranteed investment certificates (GICs), they may not offer high enough returns to meet your investment return objectives. To save for retirement, you'll likely want to consider other possibilities, like stocks, to include in your portfolio mix. Stocks carry more risk but offer higher potential returns.
Your emotional risk tolerance is also important
There’s a more subjective risk tolerance factor that’s also very important — let’s call it your emotional risk tolerance. This is a measure of how comfortable you are seeing your account balance fluctuate as financial markets move. It’s also about how you react to the potential for losing money.
There are good reasons why price fluctuations can make an investor nervous, and uncertainty makes some investors more uncomfortable than others. Nervousness could be based on a practical reason — you may need the money in the near future and have no other alternatives. But some investors are inherently less comfortable with volatility, regardless of their circumstances. This can change with more investing experience and changes in life situation, but it’s important to acknowledge your own tendencies. Your tolerance for risk should match the investments you choose; otherwise, it’s hard to stay committed to your investment plan.
Risk tolerance can change over time
Your risk tolerance can change as your financial situation and goals evolve. For example, your risk tolerance might increase as you build assets and get used to the ups and downs of financial markets. It might decrease when you encounter stressful life events, like losing a job or unexpected big bills to pay, or when you’re closer to needing the money. This is part of the reason that retirement portfolios often become more conservative as an investor nears retirement.
Diversify to lower your portfolio risk
No one likes to see their portfolio value decline, but one way to lower that possibility or reduce its severity is through diversification. With diversification, you include various types of investments in your portfolio: different kinds of stocks, fixed income and cash. With this mix, you’ll have, for example, the chance to benefit from the growth of companies that are innovating and growing quickly, but your overall portfolio won’t take as big a hit if that growth slows for a time. This is based on the simple idea that some investments do well under certain economic conditions while others lag. Later, in a different economic climate, the lagging investments might strengthen, while previous highflyers could pull back.
We’ll talk more about diversification in another lesson.
