Lesson 2: What is your risk tolerance?
How nervous do you get about the potential for loss?
CIBC Investor’s Edge
4-minute read
When you’re deciding what to invest in, one of the things you have to take a close look at is: yourself! You need to look at some objective things about your situation such as how long you plan to keep this money invested and what it’ll be used for. Then there’s a more subjective factor that’s also very important — let’s call it your emotional risk tolerance. This is really a gauge of how comfortable you are seeing your account balance fluctuate as financial markets move and your potential for loss.
We’re not judging here. There are very good reasons why fluctuations can make an investor nervous. It could be their personality — maybe uncertainty just makes them uncomfortable. It could be something more concrete, like the fact that they’ll need the money soon and have no alternatives. All reasons are valid, but it’s important to acknowledge them, because your tolerance for risk should match the investments you choose. Otherwise, it’ll be difficult to stay committed to your investment plan.
Let’s also acknowledge that your emotional 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 could also decrease when you meet stressful life events, like losing a job or having unexpected big bills to pay, or when you’re closer to needing the money, maybe for a big purchase.
A few basics about risk and choosing investments that are right for you
The value of a risky investment is more likely to fluctuate than the value of a conservative investment
Most investments fluctuate in value, but some fluctuate more than others. For example, you can 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 from month to month. However, the start-up has much greater growth potential as compared to the consumer stock, which will likely just match the growth rate of the overall economy.
If you’ll need to count on the availability of a certain amount of money on a specific date, especially if it’s in the near future, that should affect your investment choices. You’ll likely want to know that your money won’t be fluctuating to the downside close to the time you want or need to spend it. This is part of the reason retirement investment portfolios often become more conservative as the investor nears retirement.
Riskier investments might give you a better chance for a higher return in the long term
Riskier or more aggressive investments can potentially provide a higher return over the long term, but they’ll probably fluctuate more in value in the years along that path. Also notice that although riskier investments have more potential for higher returns than more conservative investments, a higher return isn’t guaranteed. Investments in risky assets can sometimes result in large losses.
It’s very important to consider your time horizon
We keep talking about your time horizon — when you’ll want to spend the money you’re investing — and that’s a very important consideration. Knowing your time horizon lets you figure out the right balance of risk and potential reward when choosing investments. With a long time horizon, riskier assets, with their potential for higher returns, make sense — you have more time to weather market ups and downs. With a shorter time horizon, you probably want to be more conservative, since you have less time to recover from any market losses.
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 GICs (guaranteed investment certificates), 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.
You can diversify to lower your risk
Of course, no one wants to see their portfolio value decline. One way to lower that possibility when investing is through diversification. With diversification, you include different kinds of investments in your portfolio. The idea here is that some investments will do well under certain economic conditions and others will lag. Later, when the economy is in a different phase, the lagging investments could start to move higher, while some of the other investments now start to lag.
We’ll talk more about diversification in another lesson.
