There are two aspects to the concept of risk tolerance: your ability to take risk, and your willingness to take risk.
Ability to take risk depends on your total financial resources and the impact of potential losses to achieving your financial goals and your desired standard of living.
Willingness to take risk is very different and with a greater emotional component. Confusing the two can lead to financial difficulties.
Assessing your willingness to take risk
To help determine your willingness to take risk, answer these questions honestly, do not answer how you think you ought to answer, but the way you really feel.
Question 1
How strongly do you agree with this statement: Generally, I prefer investments with little or no fluctuation in value, and I’m willing to accept the lower returns usually associated with these types of investments?
- Strongly agree
- Agree
- Neither agree nor disagree
- Disagree
- Strongly disagree
Question 2
When some investment advisers use the term risk, they think of it as having two parts: the risk that the value of your investments may fluctuate up and down so much that you worry a good deal about it, or that you may worry that you will not meet your financial objectives. If pressed to choose, which is your greater worry?
- Worrisome fluctuations in the value of my investments.
- The possibility of failing to meet my financial objectives.
- I cannot choose between the two as they are equally worrisome.
- I cannot choose between the two as I don’t worry about either of them.
Question 3
On a quarterly statement of your investments your balance declined 30% from the previous quarter. How would you likely react?
- I’m not concerned – I know that investments go up and down in value.
- I’d be concerned, but wouldn’t lose any sleep over it.
- I’d be very concerned and would be wondering what, if anything, I should do.
- I’d be panic-stricken and wonder if I should find another investment adviser.
- I’d immediately fire my adviser and look for someone else.
Your answers should help you determine whether your current investments are appropriate for you and serve as a basis for choosing future investments.
If you’re considering having an investment advisor manage your investments, it is critical that you consider both your ability and your willingness to take risk before any investments are even discussed.