We’ve all heard the expression, “The greater the risk, the greater the reward.” There’s no more fitting application of this principle than when investing in the stock market. The foundation of a positive investment strategy relies on an understanding of the investor’s level of risk tolerance. While investing in the stock market involves an inherent tolerance for at least some risk, the degree to which one is comfortable with risk will change with time. Maintaining a positive dynamic between your financial goals and your risk tolerance can be a balancing act which requires judicious reassessment along the way.
Understanding Risk Tolerance A comprehensive financial strategy relies on your tolerance for risk as an investor. In most cases, this is heavily influenced by one simple factor: your time horizon. While this figure is indeed important, there are other factors at play, such as when you’ll need the money and your spouse’s risk tolerance level, if you are married.
Risk Tolerance: Three Types of Investors
Investors can generally be broken down into three levels of risk tolerance.
Conservatives have the lowest tolerance for risk, prioritizing the safeguarding of their principal investments from market fluctuation by choosing the lowest risk investments. That’s not to say this method is foolproof as conservative investors take on a different risk: insufficient growth assets. Failure to outpace inflation can result in inability to reach long-term goals, decreased spending power and an eventual reduction in your standard of living.
Moderate investors have a higher tolerance for risk, and are more likely to seek out mid-range investment opportunities, including both fixed income and equity investments, with potential for long-term returns. These investors trade an average amount of risk for average return potential.
Aggressive investors are the least risk-averse of the three profiles, and are willing to overlook short-term losses in order to maximize growth potential. These investors maintain a long-term market perspective which supersedes reacting to immediate market fluctuations. This approach is generally adopted by those willing to take on high risk for high return potential over an extended period of time.
Changing Risk Tolerance
Your tolerance for risk will vary during the different phases of life. The biggest change to risk tolerance typically occurs with the switch in focus from saving money to generating income from savings during the retirement years. At this point, an investor’s comfort with risk will typically decline, and assets should be reallocated accordingly. Still, investors should resist the temptation to avoid risk entirely, as some growth-oriented assets are necessary to remain on financial target. Diversification is critical; by selecting investments across a broad range of asset classes, you can achieve moderate growth potential at tolerable risk levels. In doing so, you help your principle continue to grow while simultaneously generating income. Risk and reward are two sides to the investment coin, but can be weighted in one direction or the other depending on the amount of acceptable volatility, as influenced by factors such as stage of life. While no investment will come free of risk, by reassessing your assets as you move through different phases of life, you can ensure that the rewards prevail over the risks for a beneficial financial outcome from your early investment years through retirement.
NOTES TO TAKE:
Strengthening your household’s financial outlook can depend upon understanding your risk tolerance.
With retirement just around the bend, adjusting your risk tolerance levels can lead to prosperity.
Joanna Hughes is a freelance writer and blogger that shares content and ideas for reputation.com and other well-known sites across the internet.
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