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Thursday, February 3, 2011

Investing: Determining your risk tolerance

Investment risk tolerance is a measure used by investors and financial planners in investment planning. The risk tolerance scale is also a useful risk management tool and ranges from low to high with the lower end of risk tolerant investors choosing financial instruments such as insured bank accounts or financial instruments and/or guaranteed investments such as certificates of deposits, bonds and money market accounts.

These basic types of risk are also comprised of more in depth risks that once elaborated upon sometimes change the actual risk level of some financial instruments that may usually be classified as low or high risk. This article will discuss the types of risk tolerance, risk types and provide tips on determining individual risk tolerance. The video below offers a helpful introduction to investment risk and how investment goals and decision affect that risk.


How to determine risk tolerance


To find an ideal risk level involves assessing and combining 1) financial goals, 2) personal perspective, and 3) life decision history with the realities of the financial markets such as percentage price losses, market volatility, personal comfort and amount invested. A simple way of looking at risk tolerance involves identifying how much general risk one likes to take financially in terms of a low to high scale.

The following link provides an example of a basic risk tolerance scale. This scale does not illustrate the types of investment associated with each type of risk, however additional graphics do, this risk/investment pyramid being one example. The difference between the scale and the pyramid is that the pyramid includes investments associated with each level of risk. However, what the pyramid does not illustrate is the finer details within each risk group and investment choice.

Investments are not always as black or white; or right or wrong as some risk illustrations seem to imply. This is because there are different types of risk within each risk category. For example, of the lowest risk level, which bonds are the safest? or which companies providing certificates of deposit are most financially solvent?

What may seem to be low risk, might actually be quite a high risk if the financial institution(s) issuing the investment instrument are doing so with a low credit rating or precarious business financials. This is why it is important to look beyond the simple risk diagrams often used in determining risk tolerance.

Types of risk and individual investment choices


As we have seen, there are essentially between three and five types of risk that may include very high, high, medium and low. To identify which one is most comfortable think back to times when such risk was occurring in life. For example, one might think about questions such as how it felt, what was the response to it, was it easy to stay emotionally balanced during the risk and what happened next.

Once one has an idea of what kind of risk one feels comfortable with, the next step can involve applying those thoughts and feelings to one's finances. Would it feel the same to have such risk levels in one's financial investments and what level of risk would be right both in terms of financial needs and goals. To further illustrate the types of risk one may be exposed to it can be helpful to understand which investment circumstances are affiliated with each type of risk.

• Financial market risk

Each financial market has a different level of risk per se. For example, the bond market tends to be more predictable and provide more stable outcomes than stock trading, but has less potential for gain. Furthermore, the Foreign Exchange market can be thought of to have high risk as the chance of losing money in this market can be high just as the chance for making money can be great. Choosing which financial markets to invest is a way to invest with risk in mind.

• Price volatility

When investing in the stock market, prices can be volatile within double digits percentages either up or down within as little time as a few hours. This can mean an investment could lose as much as 20% or more if an adverse event, sudden unfavorable economic news or weak market conditions strike one's investment. Being prepared both financially and mentally for such risk is a key part of risk comfort. If one would rather not expose oneself to such risk there are other ways to invest and avoid such risk.

• Investment choice

The choice of one's investments is also a way to identify and invest with risk in mind. Bank insured and guaranteed investments are among the safer of investments, followed by treasury bonds, conservative mutual funds, blue chip stocks, growth stocks, and futures trading in that order. One may wish to try a little in each to determine what one feels most comfortable with before deciding which risk level is right.

Tips for determining risk level


• Market simulations may help one get the feel for which type of investing one is comfortable with. Such programs do not involve real cash are thus risk free, but help one identify potential risks and pitfalls within that financial market.

• Invest Conservatively at first to see how it really feels, to make and lose real money. The first hand experience shows what is really involved both financially and mentally.

• Personal history of decision making is a clue to one's risk preference. In life many decisions and choices are made, if such choices were often risky or less risky, this may be a good indicator of what type of investment risk one will prefer.

• Study and research investment choices and financial markets to garner a more exacting level of risk. Each market and investment has a life of its own and may not always be a good predictor of other similar investments.

Investment risk is something one may intuitively know beforehand or have to think about before investing. If one has to think about it a lot, this may imply one is naturally cautious regarding investments. However, caution alone may not determine risk preference. The above illustrations and tips can assist with such identification of risk levels, how to deal with those risk levels and which investments are more likely to yield each risk level.