How Should Your Risk Tolerance Influence Investment Decision?

As an investor, how much risk can you tolerate? It’s an important question — because the answer can help you make the right investment choices.

Before you know your risk tolerance, you’ll want to make sure you first understand the nature of investment risk — the risk of losing principal. This risk is especially prevalent when you invest in stocks, because stock prices will always fluctuate — and there are never any guarantees about performance. Of course, a decline in value does not mean you need to sell; you can always hold on to the stock with the hope that its value will bounce back. And this can certainly happen, but again — no guarantees.

How you respond to this type of investment risk will tell you a great deal about your own risk tolerance. Of course, no one, whether he or she has a high tolerance for risk or a low one, particularly likes to see declines. But people do react differently. If you’re the sort of person who can retain your confidence in your investment mix and can focus on the long term and the potential for a recovery, you may well have a higher tolerance for risk. But if you find yourself losing sleep over your losses (even if, at this point, they’re just “paper” losses), becoming despondent about reaching your goals, and questioning whether you should be investing at all, then you may have a low tolerance for risk.

This self-knowledge of your own risk tolerance should help inform your investment decisions — to a point.

Even if you determine you have a high tolerance for risk, you almost certainly should not load up your portfolio exclusively with stocks. If the stock market enters a prolonged slump, you could face heavy losses that may take many years to overcome, causing you to lose significant ground in the pursuit of your financial goals. Conversely, even if you discover you don’t have much tolerance for risk, you won’t want to invest only in supposedly “safe” vehicles, such as certificates of deposit (CDs). During those periods when rates on CDs and similar instruments are low, as has been the case in recent years, your interest payments from these investments may not even keep up with inflation — meaning that, over time, you could end up losing purchasing power, which, over the long term, can be just as big a risk as market declines.

Ultimately, then, you’ll probably want to let your risk tolerance guide your investment choices — but not dictate them with an “iron hand.” So, if you believe you are highly tolerant of risk, you might have a somewhat higher percentage of stocks in your portfolio than if you felt yourself to be highly risk-averse — but in any case, you’ll likely benefit from building a diversified portfolio containing stocks, bonds, government securities, CDs and other investments. While this type of diversification can’t guarantee profits or protect against loss, it can help reduce the effects of volatility on your portfolio.

By knowing your own risk tolerance, and the role it can play in your choices, you can help yourself create an effective, suitable investment strategy — one that you can live with for a long time and that can help you avoid the biggest risk of all: not reaching your long-term goals.

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