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Question:


What is risk tolerance with regard to investing?
-DebbieG


Answer:


Risk tolerance refers to two related factors: how big a loss can you stand in the value of your investments within a given period, say one year, five years or 10 years, and how big a loss you’re prepared to endure during that time. The first is a matter of personal finance – how great a potential hit can you take to your standard of living? – and the second is about psychology – how big a hit can you take emotionally? Whatever your risk tolerance is, of either type, will determine which mix of investments is most suitable for you, and that, in turn, will play a big role in determining how much money your assets are likely to make for you over the years. That’s because the long-term returns of different types of investments correlate highly with their volatility, or the maximum loss that they incur over any given period. Stocks tend to return more than bonds, for instance, but they also tend to undergo the largest ups and downs along the way.

Because the risk of loss is higher for stocks, and perhaps even higher for assets like gold and other commodities, financial advisers encourage investors to limit their holdings of them as they get closer to retirement and will begin depending for their livelihood on the income and gains that their investments produce. By contrast, young people who won’t be relying on their investments for many years are advised to keep large proportions of their wealth in stocks because they’re expected to generate stronger returns between now and when they will need to draw money from their portfolios. By definition, young people have more of the first kind of risk tolerance.

Regardless of how much risk is appropriate for investors depending on their personal financial circumstances – besides age, how much wealth they have in general is a factor, as is the number of dependents they have – some people, due to their psychological makeup, are prepared to take more or fewer risks with their money. Where they can get into trouble is with extreme market conditions that force them to discover that they really weren’t as tolerant of risk as they had thought. Some investors who were confident that they could withstand a 50 percent loss in the stock market nevertheless panicked during the financial crisis of 2008-09 when confronted with that outcome. They sold at the bottom, and then the fear that belatedly set in kept them out of stocks when the market went back up. When deciding how much risk is acceptable, therefore, it’s good to know what’s suitable for your personal circumstances and also for your personality. Listen to your financial adviser, if you have one, and listen closely to your gut, too.

-Conrad de Aenlle



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