After being in the investing world for a while, you may have heard risk tolerance. It define as the amount of risk you are capable to take in your investment.
Before any investors choose the type of investment working best for their financial goals, measuring and determining the risk tolerance should come first. Once an investor knows the level of their tolerance, then, he or she can choose the investment type that suits his or her risk profile.
Commonly, many financial planners categorize this tolerance as aggressive, moderate, or conservative.
Defining Risk Tolerance
Risk tolerance closely related to the market risk, including the ups and downs of the market (volatility), that an investor capable to take.
In determining the risk tolerance of the investors, a financial planner usually uses a calculator or a questionnaire. The result of that questionnaire will show if an investor is an aggressive, moderate, or conservative questionnaire.
Ways to Measure the Risk Tolerance
If you use the help of a financial planner, you will get a questionnaire consisting of a set of questions about many different market scenarios. You, as an investor, have to anticipate that situation and answer the question accordingly.
The example of the question is like, “What will you do if you experience a market fall by 20% in one year? You will a) Wait a few months to make the decision, b) Sell your stock immediately, or c) Do nothing.”
If your answer is to “Do nothing.”, then you are an aggressive investor. But, if your answer to that question is “Wait a few months ….”, then you are a conservative investor. Lastly, if your answer is “Sell stocks immediately.”, then you are a conservative investor.
From the result of that questionnaire, the financial planner can build an investment portfolio that is suitable for you.
The Truth about Market Risk
Many investors believe that they are aggressive investors, while the truth is they are moderate investors. These people immediately sell their stocks once the price of stock portion of their portfolio falls dramatically.
Even with the knowledge that understanding your risk tolerance can significantly help you build your portfolio, yet, predicting or controlling your future action during that specific moment remains hard.