How to Calculate Risk Tolerance

Your risk appetite can be reflected in your everyday life.
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Do you stomp on the accelerator through a yellow traffic light, or come to a complete stop at a four-way intersection? Parasail over blue water on vacation, or read a good book on the beach? Ah yes, there are clues to your risk tolerance in everyday life. But when it comes to investing, your risk appetite is determined by when you will start cracking open that nest egg, your planned retirement lifestyle -- and your “sleep-at-night” factor.

Long-term Risk

To calculate your risk tolerance you must consider what investment professionals call your “time horizon.” If you are young and just beginning to invest for retirement you may want to consider a healthy portion of riskier investments, like stocks. Equities have the potential for higher returns over the long term when compared to interest-generating “savings” investments -- like CDs and money market funds -- that have less risk but less return. Investors often make the mistake of putting “long-term” money into investments that pay only a small amount of interest.

Short-term Risk

If you plan to retire within five years or so, you will want to pare down riskier investments. Without that risk adjustment, you might experience a sharp market downturn -- which would eat away at your principal -- or be forced to sell a stock for cash needs and take a loss.

Aversion to Loss

Many investors underestimate risk when markets are booming and overestimate it when markets tank. From the U.S. stock market's 2007 high to its 2009 low, stocks lost more than half their value. On the other hand, intermediate-term government bonds rose about 6 percent. During that same period, a portfolio of 90 percent stocks and 10 percent bonds fell 45 percent, while a portfolio of half stocks and half bonds lost about 22 percent. While you cannot avoid losses completely, you certainly can cushion the fall. Your risk appetite must be your guide.

Risk versus Goals

If your goal is to be a millionaire by the time you retire but your risk profile says you might only make it to being a thousandaire, you’ve got a problem. There can easily be a gap between your goal and your gut. Rather than taking more risk than you are comfortable with in the quest for your financial goal, you may opt to save more, work longer, or adjust the retirement dream from a seaside resort to a lakeside cottage.

Test Your Tolerance

Risk tolerance questionnaires aim to quantify your appetite for loss and come in many styles, from clinical to informal. By taking these surveys, which ask similar questions in different ways, you may discover more about your personal risk tolerance.

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