Investment Tips - Know Your Risk Tolerance

Investment Tips – Know Your Risk Tolerance  (image credit)

A recent copy of Forbes magazine has a list of 365 tips on investing to get rich.  I thought I’d go through some of the ones I found the best and expand on them to provide a more detailed discussion.

Today’s investment tip is: “know your risk tolerance.  Pick an asset allocation that lets you sleep at night, so you won’t panic and sell stocks at the bottom.”

Know Your Risk Tolerance - Background

What is an asset allocation?  Well, this is simply the investment breakdown you select between different assets such as: stocks, bonds, real estate, cash, precious metals, etc.  Some asset allocations are risky (such as 80%+ stocks) and some are pretty conservative (such as mostly cash and 60%+ bonds).  The amount of of long term reward investors can expect depends on the amount of risk they are willing to take.  Folks looking for high long-term returns will have to take on considerable risk.  The point of this tip is to not bite off more than you can chew by taking on more risk than you’re comfortable with.

Know Your Risk Tolerance - My Take?

I think this investment tip is spot on!  When I was younger (and stupider),back in 2008 when the market crashed I really did bite off way more risk than I could take.  By investing in individual companies, using leverage, and trading in futures, I was definitely way in over my head.  I was taking on WAY too much risk for what I was mentally able to handle.  I was very inexperienced with investing at the time.

What was the result of this?  You can probably guess – I lost a ton of money by selling close to the bottom of the market!  Just like what this tip is trying to help us avoid.  If I would have invested in more “boring” index funds and had a healthy amount of bond investments, I probably would have fared much more favorably.

You may be asking: “how do I know my risk tolerance if I’ve never invested before?”  I’d answer that great question by saying: “you don’t – so assume your risk tolerance is low!”  It’s better to get a slightly lower return for a few years while you learn the ropes of investing by taking a more conservative investing approach than to go hog wild and get really aggressive.  If the market corrects and you sell your investments for a huge loss because you aren’t ready to handle the pressure of a short term loss, you really won’t feel all that good about things :-)  For beginning investors, I really think the old adage “better safe than sorry” aptly applies here.

Know Your Risk Tolerance - Final Thoughts

This tip is excellent advice for folks that are “newish” to investing.  It can help keep us out of the hot water by tempering the huge swings in our portfolio’s value if we’re not ready for that type of emotion yet.  Many books write on the topic of new investors who routinely overestimate their risk tolerance.  If you are a new investor, then I’d take this advice to heart and err on the side of caution when selecting your asset allocation.