Building your investment portfolio is dependent on your ability and willingness to take on risk. The more you’re willing to take, the higher your potential returns … and losses. Your risk tolerance depends on your risk capacity and your risk willingness, and is affected by age, stage in life, and goals.
If you’re investing for retirement and are 45 years old, you have more time to grow your money and can take on more risk than a 65-year-old can. With 30 years to build a nest egg, your investments have more time to ride out short-term fluctuations with the hope of receiving a greater long-term return.
Important factors include your time horizon (length of time of your investment) and your risk tolerance. These help you get an idea of which investment strategy, from conservative to growth-oriented, corresponds with your investor profile.
When you’re afraid of taking on risk that could cause a decline in your portfolio’s value, you’re risk-averse and more conservative. When you want larger gains and are willing to take on more risk, you’re a risk-seeker, leaning toward growth. Most people are in the middle.
If you have a lot of liabilities (debt) and little cash assets, you’ll tend to be risk-averse because you can’t afford to take on risk. If you have large cash assets and few liabilities, you’re better positioned to take on risk.
Modern financial planning utilizes two independent risk scores: risk capacity and risk willingness. Risk capacity is based on your investment objectives, initial investment amount, and time horizon. This addresses your ability to handle risk and the primary investment goal.
Risk willingness indicates how willing you are to accept investment risk in terms of volatility of investment returns as well as the probability of loss.
