Investing is inherently intertwined with risk, but the degree to which you can withstand the ups and downs of the market plays a critical role in your investing journey. This ability, commonly referred to as "risk tolerance," should ideally be a measure of how willing you are to absorb losses in your portfolio. In this article, we explore how to determine your risk tolerance and effectively integrate it into your investing strategy.

The Psychology of Risk and Reward

Behavioral science has shown that investors despise losses roughly two and a half times more than they appreciate gains. It's an emotional response most of us can associate with — the sting of a financial loss seems to outweigh the joy brought by a gain. However, to become a successful investor garnering long-term equity-like returns, it's crucial to reconcile with some level of risk that's innate in the stock market.

Can you imagine witnessing a 20% loss in your portfolio without being tempted to offload all your equity holdings? If yes, you probably can handle a substantial allocation to stocks. Conversely, if the mere thought of loss keeps you up at night, fixed income investments might be more suitable for you.

Finding the Right Balance

Most investors fall somewhere in between these two extremes, meaning they're not entirely averse to risk, but they're not quite ready to put all their eggs in one, potentially risky, basket either. This is where a seasoned financial advisor can make a significant difference by helping create an asset mix that aligns with your risk tolerance and investment goals.

Remember, equities have consistently delivered solid long-term returns for investors. But, it's the intermittent bear markets and corrections that tend to deter all investors from fully realizing these returns. Why? Because the fear of losing money often causes them to sell stocks prematurely, thereby missing out on subsequent rebounds.

The Measuring Stick: Risk Tolerance Assessment

Risk tolerance should not be based on gut feeling or a hasty reaction to market fluctuations; instead, it should be the outcome of a structured assessment process. This process includes questionnaires or surveys designed to gauge your emotional reaction to potential losses and gains, as well as your financial capacity to endure losses without hampering your lifestyle or financial goals.

Once your risk tolerance is determined, it becomes a key input to devising your investment strategy. For example, if you have high-risk tolerance, your portfolio might include a significant proportion of equities, whereas, with low-risk tolerance, your portfolio could be skewed towards bonds or other fixed-income investments.

An Ever-Evolving Measure

It's important to note that risk tolerance isn't a static measure. Life events, changes in financial circumstances, or simply getting older can all affect your risk tolerance. Regularly reviewing and adjusting your investment strategy in line with shifts in your risk tolerance can help ensure your portfolio stays aligned with your evolving needs and goals.

In conclusion, understanding and measuring your risk tolerance is an integral part of your investment journey. It's not about completely eliminating risk; rather, it's about finding a balance where the level of risk you're taking on is in harmony with your emotional well-being and financial capacity. This balance allows you to confidently navigate the investment landscape, ready to embrace the rewards that come with calculated risk-taking.

Summary

Your risk tolerance should be a measure of how willing you are to absorb losses in your portfolio.

Studies in behavioral science show that investors loathe losses about two and a half times more then they enjoy gains. Everyone can likely relate to this stat.

But, to be a successful investor that achieves long-term equity like returns, one has accept some level of risk inherent in the stock market.

Would you be capable of absorbing a 20% loss in your portfolio, and not be tempted to sell all of your equity holdings? If so, you can likely handle being largely allocated to stocks.

Are you very sensitive to loss, and just do not want to see your portfolio balance drop below where it is today? Then fixed income is probably a better solution for you.

Most investors fall somewhere in between, which means working with your financial advisor to create an asset mix that meets your needs.

Over time, equities have proven time and again to deliver solid long-term returns to investors, it's just the bear markets and corrections along the way that prevent all investors from realizing them (spooked investors often sell stocks before participating in rebounds).

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