What is risk tolerance? And how can you assess yours?

Knowing your investment risk tolerance level is essential for successful investing. Here’s why risk tolerance is so important and how to figure out how much risk is right for you.

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Most investors know that risk and return go together. Generally, lower returns mean lower risk and vice versa. When it comes to acceptable levels of investment risk tolerance, however, everyone’s different.

So, what is risk tolerance, exactly? Generally, it’s how much risk you’re willing to take to reach your investment goals. This typically depends on several factors, so it’s really important to establish your own risk tolerance before you even start investing.  

The three types of risk tolerance

Conservative

Conservative investors’ key concern is keeping hold of their capital. It’s more important to them to avoid losing money than making it. For this reason, they usually invest in assets that typically ensure a return of principal, such as GICs and bonds.  

Moderate

Investors with a moderate investment risk tolerance strike a balance between growing their money and protecting it. They will take on some risk but will temper it with the amount of loss they are willing to accept. Moderate-risk investors will typically hold some high-risk assets, such as equities, as well as safer investments like bonds. They will usually earn more in rising markets than conservative investors but lose less than aggressive investors when the market falls.

Aggressive

The ups and downs of the stock market are all part of the process for this type of investor. Investors with an aggressive investment risk tolerance prefer asset classes with the potential for high growth, such as equities. This can lead to higher returns when the market is doing well but the downside is that they will experience greater losses when markets dip. Market crashes don’t affect their investment goals, however: they are used to these fluctuations and know that it pays to stay the course. They also see market dips as an opportunity to buy equities at a discount.

To figure out where you are on the risk-reward investment scale, you need to go through an investment risk assessment, so you know your personal investment risk tolerance level. Risk is very subjective: for some investors, losing a few thousand dollars is small change, while for others, dropping even a couple of hundred dollars is a big deal.

Below is our risk tolerance questionnaire: by answering these seven questions, you’ll be able to better gauge your personal risk tolerance level. 

Do you understand the market?

One thing to consider is your market knowledge. If alpha and beta are all Greek to you, it’s probably wise to wade in slowly. If your nest egg is small, the payoff for taking on risk would not be that significant, so it makes sense to take it slowly until you grow your confidence and understanding.

What’s your age?

This is a really crucial one. If you’re in your 20s, you’re likely have decades to earn money and overcome any serious market fluctuations, so you can afford to have a high-risk tolerance. If you’re in retirement, however, large equity losses can have serious repercussions on your retirement income: in this case, a higher mix of safe assets would probably be advisable. 

What is your investing time frame? 

On the whole, the longer you intend to hold onto your investments, the greater the risks you can take. If your financial plan means you need a certain sum of money in 30 years’ time, you can take greater risks (and aim to grow your money faster) than if you needed that money in two years’ time. The market has always grown over the long term, but it can take it a year or more to fully recover from some dips.  

What are your investing goals?

Everyone has different financial goals, and this should have a bearing on how much risk you need to take on. If you want to reach $1 million in investments by the time you retire in 30 years, then you can — and probably should — take on greater risk than someone who needs to save $10,000 in two years. A good financial plan will determine how much you’ll need to invest, over a set time period, with a risk tolerance level that will help you to reach that goal.  

Have you experienced investment losses?

If you’ve been through a market slump, think about how it made you feel. Did it cause you to pull out of your investments and sit on the sidelines or move into safer investments? Did it cause you emotional stress or were you able to stick to your plan, knowing that your investments’ value would eventually recover? Answering these questions will give you a good read on your risk tolerance.

Do you have money to fall back on?

If you have significant income or other investments (such as real estate or a trust fund), taking on high risk could be more of an option. However, if you depend on your investment dollars to live, your risk tolerance should be low.

Do you know how much you could lose?

It can be harder to evaluate how much of decline in investments you can stomach when you think about potential losses in percentage terms. Dollar terms can make it more concrete: instead of a 30% drop, tell yourself that it’s a $30,000 drop. How would that make you feel? 

How to put your personal risk tolerance to work

Once you’ve figured out your investment risk tolerance, you need to identify ways to maximize the potential for higher returns in your investment portfolio, while also managing risk.

Markets fluctuate, but studies have proved that investing over time delivers much higher returns than dipping in and out of the market. Spread out the risk by diversifying your portfolio and using asset allocation so your portfolio contains a mix of investments that best suits your goals and risk tolerance.

Talk to your IG advisor: they can take you through an investment risk assessment to gauge your investment risk tolerance level. They can help build a portfolio that suits your risk level and your investment goals, so that you won’t need to panic whenever the market falls. If you don’t have an IG advisor, you can find one here

Written and published by IG Wealth Management as a general source of information only, believed to be accurate as of the date of publishing.  Not intended as a solicitation to buy or sell specific investments, or to provide tax, legal or investment advice.  Trademarks, including IG Wealth Management and IG Private Wealth Management are owned by IGM Financial Inc. and licensed to its subsidiary corporations. Insurance products and services distributed through I.G. Insurance Services Inc. (in Québec, a Financial Services Firm). Insurance license sponsored by The Canada Life Assurance Company (outside of Québec).