One of the most important decisions that investors can make is selecting investments that match their risk tolerance. Risk tolerance is an investor’s capacity to handle the uncertainty that accompanies the selection of specific investment products such as stocks and bonds. For example, bonds are subject to interest rate risk (where bond prices fall as interest rates rise and vice versa), and stocks are subject to market risk (where general stock market trends affect the performance of individual securities).
Risk tolerance has been referred to as the “sleep at night factor,” as in “how much investment risk can you withstand and still be able to sleep at night?” It involves feelings and emotions as well as experiences with managing money. When people invest beyond the limits of their risk tolerance, they often experience physical symptoms of distress, including sleeplessness.
What factors determine investment risk tolerance? This question is still the subject of much research so there is no definitive answer. Not all the related factors are financial ones, however, such as income and net worth. An investor’s knowledge about investing, previous investment and business experience, and attitudes about risk taking in general can also influence risk tolerance.
Rutgers Cooperative Extension has an online Investment Risk Tolerance Quiz available at http://njaes.rutgers.edu/money/riskquiz/. The quiz includes 13 questions and provides users with feedback about their capacity to handle investment risk. The higher the total score, the higher (i.e., more aggressive) someone’s investment risk tolerance. Quiz questions are based on both thoughts about risk in hypothetical situations and current investing behavior.
When online users complete the risk tolerance quiz, they receive a score and information to interpret it (i.e., to determine whether they are a conservative, moderate, or aggressive investor). Data collected from quiz users collectively is also compiled and analyzed. An important finding over time is that quiz takers’ risk tolerance is positively associated with market indices such as the Dow Jones Industrial Average. In other words, people are more willing to take investment risk when markets are performing well and more reluctant to take risks during market downturns.
Ideally, investors’ risk tolerance level should remain about the same during bull and bear markets. For example, if they are comfortable with the risk of loss of principal that is associated with stocks and growth mutual funds, they will feel this way whether stock market indices are rising or falling. Their investment asset allocation (i.e., the percentage of one’s portfolio held in stocks, bonds, and cash) will probably get more conservative, however, as they get older.
What if your investment risk tolerance is not as high as you previously thought? First, realize that you are not alone, as this is a common situation experienced by many people, especially recently.
Below are six suggestions to bring your investment decisions in line with your true risk tolerance level:
• Increase your knowledge of investing to understand the risks involved.
• Place new investment money (e.g., future retirement savings deposits) in less aggressive investments.
• Consider selling stocks or stock funds that have under-performed market indexes for a year or longer.
• Avoid risky investments such as sector funds, aggressive growth funds, and penny stocks.
• Keep a long-term view and avoid reacting to daily investment performance indicators.
• Never invest in anything that you don’t fully understand or can’t explain simply to another person.
Finally, determine your preferred asset allocation strategy going forward. It should be in line with your true risk tolerance; i.e., how you really feel about investment risk following the recent bear market and not the risk tolerance you thought you had during the last bull market. While a variety of online calculators can assist you, another good way to determine your investment risk tolerance is to “go with your gut” and ask yourself “can I sleep at night with this investment?”
