You're a sensible person, but sometimes you throw caution to the wind.
You are not alone. Most people are both risk-takers and cautious, depending on the activity.
Risk tolerance is one of the basic factors in determining your best investment strategy. Your tolerance can affect both the types of investments you make and how you diversify your portfolio.
So, how do you know how much risk to take with investments? To start, here is a short – and unscientific – quiz to learn more about yourself.
Do you put on the brake when the traffic light turns yellow or do you step on the gas? If you brake, give yourself one point. If you step on the gas, collect three points.
Do you fill the gas tank when the needle reaches halfway or do you run a few miles on empty? If you fill the tank halfway, give yourself one point. If you run on empty, score three points.
Do you take the long way because it's the way you know or will you take a shortcut never taken before? If you take the long way, score one point. If you take the shortcut, give yourself three points.
Do you take the train long distances or do you fly? If you take the train, give yourself one point. If you fly, collect three points.
Add your points. The maximum is 12; the minimum is 4.
Those with a higher score can accept a relatively great amount of risk and are referred to as risk tolerant. Those who scored low can accept very little risk and are referred to as risk averse.
Many people fall in between the two ends of the spectrum.
With investments, there are two aspects of risk tolerance:
Capacity for risk, or ability to absorb losses. This is a financial metric. For example, an investor who depends on investments to pay daily expenses has less risk tolerance than someone for whom a loss might just be an inconvenience.
Comfort level with risk. This is related to the person's personality as well as objectives and goals, life stage, knowledge of investing and investment experience. The basic rule is to only invest as much as you are comfortable with. If you lose sleep worrying about investments, you may have invested too much or too aggressively.
Investors typically fall into three categories of risk tolerance: aggressive (those who are risk tolerant), conservative (risk averse) or moderate (somewhere in between).
In the investment world, risk means uncertainty, i.e., the possibility you may lose your investment or that it will yield less than anticipated.
Uncertainty also refers to how much the price of an investment fluctuates. The more the fluctuation, the higher volatility and the greater the uncertainty about the outcome of your investment.
Three factors are key to understanding risk (noting that all investing involves risk, including the potential loss of principal, and there is no assurance any strategy will be successful):
The risk-return tradeoff. As risk increases, the potential for return also increases. Historically, investments with greater risk tend to provide higher returns, though past results are no guarantee of future returns.
The more aggressive an investor is, the more risk and the greater chance to earn a potentially higher return (assuming any return is earned at all).
Conversely, the more conservative, the less risk and the less potential to earn a high return (though you're also less likely to lose your investment).
The time horizon. The length of time you plan to stay in a particular vehicle is important.
Generally, the longer your time horizon, the more you may be able to afford to invest more aggressively. This is because you have more time to ride out fluctuations in the hope of getting a greater reward in the future.
The risks inherent in each investment. Finally, many types of risk can affect an investment. Each investment is subject to all of the general risks associated with that type of investment.
Risk also arises from factors and circumstances specific to a particular company, industry or class of investments.
Personal and outside factors may influence your tolerance at any time or over time.
You might expect changes in your feelings about risk when there are increases or decreases in family obligations, major shifts in the economy or other circumstances. In these cases, investors often modify their plan.
To determine your risk tolerance for investing, there are tests such as psychological behavior and investment preference assessments that often provide helpful information.
That said, risk assessment is not an exact science. Moreover, risk tolerance can change as you deal with different situations and have different needs as you go through life.
With investment planning, as in many important decisions, usually it's best to speak with a professional adviser.
They have the skills and experience to ask the right questions to help you determine your risk profile and short-term and long-term goals to determine the best investment choices for your needs.