Investing and saving are two of the best ways to reach your financial goals. However, some people who are eager to save show less enthusiasm when it comes to investment. This is because when they think about investing, all they can think of is the risk – the ups and downs of the market.
If you’re looking to make your first investment, this post is for you. You want to be able to make well-informed decisions on your way to financial independence, whether you thrive on risk, or they keep you up at night. The key to investing happily is to find the right level of risk that allows you to achieve your desired return while keeping your peace of mind! That’s where risk tolerance comes in.
In this post, we’ll look at the matter of risk tolerance and asset allocation. We’ll also take a look at the factors that affect your risk tolerance and how to be a satisfied investor, no matter how high or low your risk tolerance level is.
So come along, and let’s get right into it.
What is Risk Tolerance and Asset Allocation?
Risk tolerance is simply the amount of loss that an investor is willing to withstand when making investment decisions. It is the degree of variability in investment returns that you can stomach in your financial independence journey.
When it comes to investment, risk tolerance is an important value to note. You must be realistic about understanding your ability and willingness to take large swings in the value of your investments.
Risk tolerance will determine how you react to changes in the market. Do you panic and sell immediately? Or do you wait calmly for things to settle? Will you go for higher-risk assets (such as stocks) or not? Holding higher risk assets comes at a price because stocks can be quite volatile. This volatility can cause investors to lose sleep.
Risk tolerance is a factor that influences asset allocation a great deal. Asset allocation has to do with the process of dividing your investments among different assets, such as stocks, bonds, and cash. It is an investment strategy aimed at balancing risk and reward by apportioning a portfolio’s assets according to an individual’s goals and investment horizon.
Different assets come with different levels of risk and return, so asset allocation is the process of deciding which asset to invest in.
The process of asset allocation is a personal one. As an investor, your asset allocation should be based on your risk tolerance levels. What works best for you changes at different times in your life.
Factors that Influence Risk Tolerance.
There are several factors that influence risk tolerance. They include:
#1. Time horizon:
This refers to the time that you have to invest in order to achieve your financial goal. A younger investor has a longer time horizon and may feel comfortable taking on riskier or more volatile investments. Older investors with a shorter time horizon may go for investments with less risk.
#2. Historical asset returns:
As an investor, it is advisable to review historical worst-case returns for different asset classes. This will give you an idea of the performance of various assets and help you make an informed decision.
For instance, looking at the performance of the stock market in 2020 vs 2021 will help you know assets that have had a series of bad years. That way, you will know how much you are comfortable losing based on what you have seen. This will help you make your asset allocation decision in 2022.
#3. Your future earning capacity:
Investors with high earning capacity may have higher risk tolerance and vice versa. A higher earning capacity gives an investor more room to carry out investment experiments.
#4. Other assets and sources of funds at your disposal:
When other assets are present, an investor has a higher ability to tolerate investment risks. Homes, pensions, Social Security, or inheritance are variables that can constitute a plan B.
Thus, you can take greater risk with investable assets when other assets or stable sources of funds are available.
Do you have a Different View About Risk Today than You Had Yesterday?
When it comes to investment, risk is inevitable. No matter how stable an asset is, an unchanging feature of the market is its volatility. That’s why the saying ‘No pain, no gain’ remains immutable.
As an investor, something that you must do is assess your risk tolerance. Look at all the factors that we have outlined above and determine how much money you can risk losing to get potential returns.
If you have a financial goal with a long time horizon, you may make more money by carefully investing in higher-risk assets, such as stocks or bonds. If your risk tolerance is low, then you may want to consider investing using the dollar cost average method.
Dollar-Cost Averaging
Dollar-cost averaging is a welcome choice for investors who cannot manage the highs and lows of the market cycles. It helps to minimize the impact of short and long-term asset volatility by allowing investors to invest fixed amounts of money into an asset regularly.
With dollar-cost averaging, you don’t have to worry about price fluctuations of the asset. Instead, you put in a specific amount into the investment at a stipulated time regardless of the rise and fall of the market.
What Else Can You Do?
You can also take different risk tolerance assessments for investors, including risk-related surveys or questionnaires. These will help you have different views about investing in different assets.
In addition to the above, contact the Art of Financial Planning to get help on how to manage your investments. We will give you a guide to investing with volatility and give you other investment strategies to use to grow your wealth.
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