Understanding and Managing Your Financial Risk Tolerance
November 1, 2023
There comes a moment in your financial planning when you must make a critical and painful choice: What are you willing to risk? This is not a decision to take lightly, and the answer depends on a series of personal questions.
The above questions are not minor ones, and they demand serious consideration. Your financial risk tolerance will determine where you place your money, how you make financial decisions, and what metrics you use to guide long-term financial planning.
What is Financial Risk Tolerance?
Ask yourself these questions: How frightened are you at the possibility of your financial portfolio losing 5%? 10%? 25%? Are you the type of person willing to accept significant financial risk for the possibility of major gains? Or are you someone who prefers a slow and steady approach?
Your answers can better determine your personal level of financial risk tolerance.
Financial risk tolerance is the amount of market volatility and risk of financial loss you are willing to incur in exchange for the possibility of making significant economic gains. Every financial outlay comes with risk, even the most basic. Generally speaking, the greater the risk, the greater the reward, and while there isn’t a direct correlation between these two factors, there is a relatively strong relationship. You must understand how much risk you want to absorb into your financial planning decisions.
How to Measure Financial Risk Tolerance?
Understanding how to measure your financial risk tolerance is critical to your long-term financial planning decisions.
When determining your risk tolerance, you’ll need to answer some basic questions:
- What are your financial goals? Are you hoping to grow your money for something critical, like retirement planning? Or are you looking for some luxury, like a new room in your house?
- How quickly may you need to get your money back? What timeframe are you looking at?
- How much of the amount of money you are looking to grow can you afford to lose?
- Are you the kind of person who looks at your returns once a day? Once a month? Never?
There are also objective measures that can help you answer these questions. These include standard deviation, maximum deviation, and the Volatility Index (VIX). By using objective measures such as these, you can better determine your comfort levels with certain financial decisions.
Furthermore, financial planners should be able to categorize a prospective financial decision by level of risk and explain why that particular expenditure may have a certain level of risk. Doing so can help quantify why you should make a particular financial decision.
Keep in mind that financial risk tolerance exists for individuals and businesses. As such, the decisions you make may depend on a series of personal or business-related factors. However, financial risk management for businesses tends to be mitigated by different actors than risk management for individuals. As such, companies will usually use other factors when figuring out their acceptable risk levels.
How Does Your Financial Risk Tolerance Impact Your Financial Plan?
Simply put, the importance of financial risk tolerance in your financial plan cannot be understated, as your risk tolerance levels will ultimately guide your long-term spending decisions. If you are relatively risk-averse or may need money at a moment’s notice, you would want to avoid placing your limited funds into a highly volatile financial instrument. By determining your level of risk tolerance, you can guide your financial decisions.
For example, are you the type of person who considers themselves high anxiety? Do you check your financial returns on a near-constant basis? Do you panic at the thought of losing any of your gains? In that case, a low-risk strategy is more appropriate. However, are you only twenty-five years old and not realistically considering retirement for another forty years? Can you look at the prospect of a financial loss and shrug? In that case, a riskier portfolio may be more appropriate.
Remember that avoiding the anxiety associated with financial risk doesn’t necessarily mean you will see better financial rewards. It is necessary to absorb some risk in almost any financial decision-making process. How much risk you are willing to absorb will ultimately determine how much financial reward you can generate.
Finally, it’s worth noting that context, goals, and timeframe all matter deeply. The closer you get to retirement, the less likely you will be to risk your nest egg, as you won’t have adequate time to make up any losses. If you are discussing saving for a stretch goal you can live without, you may be more willing to take on financial risk.
Everyone needs to understand what level of financial risk they are willing to accept. By determining your risk comfort level – and then using that level to build your financial plan – you can better make decisions for your long-term economic benefit.