What Is Your Risk Tolerance?

It is conventional wisdom that a younger investor can take more risk than an older investor thanks to a longer time horizon. While this may be true in general, there are many other considerations that come into play. Just because you are 65 doesn't mean you should shift your investment portfolio to conservative investments. Growing life expectancies and advancing medical science mean that today's 65-year-old investor may still have a time horizon of more than 20 years.

So, how does an individual investor determine his or her risk tolerance? Let's take a look.

Net worth and available risk capital should be important considerations when determining risk tolerance. Net worth is simply your assets minus your liabilities. Risk capital, or discretionary income, is money that you can afford to lose if your investment doesn't work out. Investors with a higher net worth can afford to take on more risk than those with limited risk capital.

If you are in the lower net worth category, try to avoid being lured into riskier investments with the potential for quick and easy profits - you could lose everything.

Your investment objectives will also determine how much risk you should assume. How much risk do you want to assume when saving for a child's college education or your retirement? For some, trading higher risk investments in an IRA can be fine - provided that you aren't risking your entire nest egg on one stock.

If you are applying your entire IRA to high-risk futures in order to shelter the high potential gains from tax exposure, you may be taking on too much risk. Futures already receive favorable capital gains treatment, and capital gains rates are lower than for regular income. 60% of your gains in futures will be charged the lower of the two capital gains rates.
With this in mind, why would a low net worth individual need to take that much risk with retirement funds?

Your level of investing experience must also be considered. If you are new to investing and trading, higher risk investment strategies should be limited until you have more experience under your belt. Even if you have the guidance of an advisor, it's important to understand exactly what you're putting your money into as well as all the risks involved. (To learn more, read Determining Risk And The Risk Pyramid.)

When your advisor asks you what your level of investing knowledge is, what will you choose? If you're a recent business grad you may choose the "medium" or "high" option. This seems to make sense, but a business grad's knowledge is likely based more on theory than on actual experience. Similarly, an investor no formal financial education but who spend hours watching CNBC and poring over financial papers may know more than an advisor about day-to-day developments.

Regardless of your risk tolerance, it's wise to always remember the old cliché and strive for preservation of capital. If you can take a big risk and still live to fight another day if a worst-case scenario unfolds, it might make sense to plunge ahead. Spreading your risk around, even if all your investments are high risk, decreases your overall exposure to any single investment or trade. With appropriate diversification, the probability of total loss is greatly reduced. (To learn more, see A Guide To Portfolio Construction.)

Knowing your risk tolerance goes far beyond being able to sleep at night or stressing over your trades. It is a complex process of analyzing your personal financial situation and balancing it against your goals and objectives. Ultimately, knowing you risk tolerance - and keeping to investments that fit within it - will protect you from complete financial ruin. (For related reading, see The Seasons Of An Investor's Life and Portfolio Management For The Under-30 Crowd.)