Understanding Your Risk Tolerance

Every investor should understand the fundamental relationship between risk and return.  Sadly however many investor the swept up the current investing fade (see tech bubble, housing bubble and peak oil) or a hot stock tip that got from a friend or so called financial guru on TV. By understanding your risk profile you can develop a long term investment strategy that will keep on the road to success.

An investor’s risk tolerance can vary based on their age, income requirements, their financial goals and knowledge and even their investment time horizon.  For example a 65 year old retiree will typically have a lower risk tolerance then a 28 year old doctor. The retiree is usually focused on protecting their capital investment and ensuring a constant income stream while a young doctor with disposable income is typically focused on growing his investment portfolio for the future.

However it is important to remember that your risk tolerance is not only as a result of your financial situation but also a reflection of your personality. Some investors simply cannot cope with the large swings that can come from investing in the stock market.  On the other hand certain investors will always seek out above average returns, even well into their retirement.

Do you know what type of investor you are?  Based on your risk tolerance investors will fall into one of these 5 categories:

Conservative Investor: Typically conservative investors have a low to moderate risk tolerance. These investors are typically uncomfortable when it comes to investing in stock market.  The primary goal of these investors is typically focused on protecting their principal investment and will forgo potential gains for a more conservative approach. These investors will usually be heavily weighted in fixed income such as bonds.

Moderate Investor: Moderate investor typically have a below average tolerance for risk.  These investors are willing to accept some risk in exchange for a higher rate of return however they are not prepared to deal with significant swings in their portfolio.

Balanced Investor: A balanced investor has an average tolerance for risk.  These investors will employ an investment strategy that aims to balance risk with a reasonable rate of return.  Balanced investors are comfortable taking on some risk. These investors will usually be equally weighted in stocks and fixed income securities.

Growth Investor: Growth investors have an above average tolerance for risk.  These investors are typically comfortable with swings in the stock market.  Growth investors are primarily focused on long term growth of their portfolio and will implement riskier strategies capable of showing above average returns over the long term.

Aggressive Growth Investor: Aggressive growth investors have an extremely high tolerance for risk.  These investors are very comfortable with significant swings in the stock market and will implement investment strategies with the goal of producing above average returns over time.  These investors will usually be heavily weighted in the stock market.

Once you have determined your risk profile you can use this information to develop your asset allocation requirements. The benefit of fixing your asset allocation before you start investing is that is makes your decision of when and how to rebalance your portfolio much easier.

Next, once you’ve determined your risk profile there is a couple of things to keep in mind.  Remember that your risk profile will usually change over time and based on your financial situation.  I’m definitely not the same type of investor that I was when I was 16 and I’m positive that I won’t be the same investor at 61.  To make sure that I fully understand my risk profile I make it a habit of completing a new risk profile survey at the beginning of each year.

Finally, you should try and remember that your risk profile shouldn’t change based on how well your portfolio is doing.  The markets move, and sometimes they swing wildly however I try to remember that that the market’s short term performance should never affect my risk tolerance and whether I should buy or sell a stock.

Here are some helpful links that will get you started in determining your risk profile:

-          RBC Wealth Management Fund Risk Profile Questionnaire

-          BMO Investor Profile Questionnaire

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3 Responses to “Understanding Your Risk Tolerance”

  1. Iain says:

    Thanks everybody for all the support

  2. It is very important to know your own investing risk tolerance. The biggest problems arise during major drawdowns. The worse the drawdown the more likely and investor is to de-risk their portfolio and miss out on teh rebound in the market. I don’t know too many investors that say “oh my, I made too much money last month. I should reduce my risk exposure”

    • admin says:

      Hi Selling Theta,
      I completely agree with your comment. By understanding your risk tolerance prior to a major draw down you decisions oh when to re-balance your portfolio become a lot easier. As long as nothing has changed in the fundamental analysis of the stock I try not to worry about the swings because I’m not planning on selling the stock anytime soon.

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