What is risk tolerance?
Risk tolerance is an investor’s ability to psychologically endure the potential of losing money on an investment. A person’s risk tolerance can change throughout his life and determines what type of investments he or she is likely to make.
Not everyone can stomach the idea of losing money on a big investment. For some people, the higher risk associated with certain investments, such as stocks, is often worth the higher reward that those investments can bring.
Risk tolerance isn’t static. It can change over time, based on a person’s financial standing. For example, a younger investor saving for retirement might be willing to purchase riskier assets because he has more time to recoup any losses.
Older investors and people who are very close to retirement are likely to have a lower risk tolerance. These investors want to choose more stable investment vehicles, such as certificates of deposit (CDs) or savings accounts, over riskier ones.
Bonds and savings accounts often don’t have a high rate of return, but they are much less likely to lose money compared to stocks.
It’s not only time that affects a person’s risk tolerance. Emotions come into play as well. Some people experience anxiety about the potential for their money to lose value, even if it’s possible for the investment to bounce back with time.
For some people, having a lower tolerance for risk throughout their lives can keep them from making investments that will best help their money grow.
Risk tolerance example
How a person saves for retirement is often a good gauge of his risk tolerance. When a person is younger and just starting to set aside money, he can afford to be an aggressive investor. Making supposedly riskier investments at a young age can help a person accrue more wealth.
But as a person gets closer to retirement, he is likely to rethink investment strategy. Older investors are generally more conservative investors. They have worked hard to build up a nest egg, and they don’t want to see its value drop with a stock market dip or crash when it’s nearly time to retire.
With a lower risk tolerance, it’s common for people near retirement to move their investments to insured options.
Whatever your risk tolerance is, check out these 10 tips for saving for retirement. Remember that it’s never too early or too late to start saving.