Understanding Your Risk Tolerance

Every investment involves some risk, and higher potential returns usually come with higher risk. Choosing investments wisely starts with understanding your risk tolerance.

Two sides of risk

• Risk capacity: how much risk you can afford to take financially. It depends on your income, savings, debts, dependents and how soon you need the money.
• Risk willingness: how much volatility you can emotionally handle without panicking and selling at the wrong time.

Both matter. Someone might have the capacity for risk but lose sleep over every market fall, or feel comfortable with risk but lack the savings to absorb losses.

Time horizon

Your time horizon, how long until you need the money, is one of the most important factors:

• Short-term goals, such as a purchase in a year or two, suit lower-risk investments like deposits, because there is little time to recover from a fall.
• Long-term goals, such as retirement decades away, can usually tolerate more risk, because markets have historically recovered over long periods.

Other factors

• Emergency fund: having one makes it easier to hold investments through downturns.
• Stability of income: a stable salary increases capacity for risk.
• Knowledge and experience.

Testing yourself

A useful question: if your investments fell 30 percent in a few months, what would you do? If you would sell in panic, your portfolio may be riskier than you can handle. Market falls of this size have happened several times, including in 2008 and 2020.