Appropriately managing your tolerance for risk will increase your potential lifetime wealth accumulation.
“Risk tolerance is the amount of risk that you can assume and generally still be able to sleep at night as an investor.”
It is helpful to have a clear understanding as to what your risk tolerance is and how it has implications on your financial planning and investing strategy.
This understanding of risk tolerance is another piece of the puzzle to consider alongside your personal tendencies and behavioral habits.
Depending on your perceptions of risk, the potential payout of taking on more risk may not be worth it. This potential is referred to as marginal utility. The marginal utility of potential payout will most likely differ based on your current net worth. A good way to look at marginal utility is by considering how much additional enjoyment or happiness you would experience from an extra $500, $1,000, or (x) dollars that you stand to gain.
Individuals that tend to be more risk-averse, usually don't gain as much marginal utility from the ability to spend an extra $500 to $1,000 when compared to risk tolerant individuals.
This then is applicable to your investment portfolio, as generally the more risk you take on the greater the variability in payout down the line and horizon. This variability is greater in magnitude in gains as well as loss, as it may mean future payouts will either result in higher future spending or a much lower ability to spend.
One's net worth plays a role in this evaluation, as a high-net-worth individual has a higher probability of being able to have a greater loss and still meet their day-to-day needs. The concept of loss aversion and impact is more severe in say a 25% loss from a portfolio worth $100,000 than that of $10 million.
Increasing your financial literacy and knowledge will positively change your ability to more accurately gauge the degree of variation in assumed risk. As financial literacy decreases so does the ability to gauge risk outcomes, and herein lies the importance of staying engaged with your financial planning.
Personally, I lean more on the end of the spectrum that embraces risk more so than being risk averse. This is not due to net worth, as I am managing my educational debt acquired thus far, but more so because I still have a longer investment timeframe.
Although there are tools that allow us to model risk, there are many factors and considerations that only you can determine. The following are some tips on how to navigate through the more common ones:
Consider your family:
Consider your goals:
Consider your time frame:
The time you have to take risk is also an important consideration as the more time you have until retirement the more risk tolerant you can and in many instances should be.
Approach risk from an evidence-based perspective: