Putting your money in the stock market is scary. If you don’t know what you’re doing or how to calculate your risk tolerance, you could be in for a nauseating ride. Taking on too much risk can lead to sleepless nights, stressed-out days, and potentially serious losses. Taking on too little risk can crimp your investment returns and make it harder to achieve your objectives.
📆 When the pandemic hit in 2020, 13 million people flocked to online trading platforms[1]. Many of them didn’t know that day trading was risky and that up to 80% of day traders end up losing money[2]. In fact, back in 1999, a NASAA report found that 70% of day traders lose money and only 12% earned a profit[3]. With these figures in mind, is it any surprise to hear all the stories about people who lost fortunes?
Risk is part of investing. Managing risk is a core element in every successful investing strategy, and the starting point of risk management is understanding your risk tolerance.
What Investing is All About
The reality of risk shouldn’t dissuade you from investing or even day trading. Instead, it should show you that there is more to investing than meets the eye. Watch out for overnight success stories where people sleep in a rag one day but wake up in a golden palace the next. Investment can be a very effective way to build wealth over time, but if you approach it as a get-rich-quick scheme you’re likely to be disappointed.
You need to start by understanding what investment is all about and how it can fit into your life.
The Core of Investing
Investing boils down to balancing two things: risk and reward. The more risk you take on, the more you stand to gain, and the more you stand to lose as well. That’s a problem because some losses are hard to come back from.
👉 On the one hand, losing money takes a psychological toll on a person. As Kahneman and Tversky pointed out in 1979, the pangs of a loss are twice as sharp as the joys of a win[4]. An excessive loss early in your investing career could make it difficult for you to step back into the market.
👉 On the other hand, there is the mathematics of the situation. Some people just can’t afford to lose more than a certain sum of money. And, even when they can afford it, they are struck by the hard, cold fact that a 50% loss will wipe out a 100% gain.
This is why you need to know how to calculate your risk tolerance before putting a single cent in the stock market. Knowing how much risk you’re prepared to accept is a key starting point for any investment strategy.
What is Risk Tolerance and Why Does It Matter?
Your risk profile looks at how much risk you can afford to take on as an investor. It tells you how to balance the asset classes you invest in, i.e. stocks vs. bonds, as well as the type of assets in each class, i.e. low-yield treasury or municipal bonds vs high-yield, junk bonds.
What Makes Up Your Risk Profile?
According to Klement (2015)[5], there are two main components to your risk profile:
- Risk aversion looks at how an investor responds psychologically and emotionally to risk.
- Risk capacity looks objectively at the investor’s situation and sees whether they can afford to take on risk.
Both of these factors are important.
👉 Even if you have the capacity to take risks, you don’t want to take on a level of risk that places you under constant emotional stress.
👉 Even if you have the will to take risks, you don’t want to take risks that exceed your real-world capacity.
Risk Aversion
Risk aversion, also labeled as risk tolerance, is a measure of how comfortable you are with risk as an investor. It is a psychological measure that tries to gauge how you would feel after a loss. While some of us might psychologically shrug a loss off and look towards tomorrow as a new day, others might find it psychologically crippling. The former investor might feel ok with an aggressive strategy, the latter should probably confine themselves to conservative approaches to investing.
There are several ways to measure your risk aversion. Some financial firms use The Grable and Lytton risk-tolerance scale , or G/L-RTS for short, to see how willing their clients are to engage in risky financial behavior. This a decent tool to assess your risk aversion. Academic studies have found that it correlates with people’s actual aversion to financial risk. And, it also has the benefit of being easy and simple to use.
👉 It’s a useful tool, but no simple questionnaire will ever fully describe your willingness to take the financial plunge.
So, what factors determine your risk aversion? You see, according to Klement and Miranda, 2012, three main factors determine our risk aversion[6]:
1. Our Genetic Makeup
Some of us are more genetically predisposed to take on risks than others. It’s just the cards we were dealt at birth. Around 20 to 40% of variations in equity investments boil down to genetic differences[7]. Researchers have even identified genomes that can explain a person’s willingness to take on financial risk[8].
🤔 So, how does this matter to you?
Well, I’m not suggesting that you go out, stick a swab in your mouth, and try to determine whether your genetic makeup makes you fit to handle risk.
Instead, if you want to calculate your risk tolerance, start by looking at your parents and your close relatives? If your parents are comfortable with financial risks, odds are you are too. The same goes for your siblings and other relatives. In fact, one study found that there is a correlation between how parents treated the riskiness that came with the stock market and how the children’s attitudes towards the stock market developed later in life[9].
2. Our Immediate Environment
The environment around us and the people we interact with day-in and day-out impact our risk aversion. To begin with, your financial adviser is bound to have a huge influence on your investment decisions[10], and you might not even be aware of it.
☝️ If you get financial advice from friends, colleagues, or family members their views will also affect your risk aversion.
In addition to that, even our communities have a significant effect on our risk aversion. Even the church we go to can influence our investing decisions[11].
3. Our Past Experiences
The biggest determinant of our risk aversion is our past experiences.
For example, a study found that people who had lived through the Great Depression and could remember its effects had on average a higher risk aversion and were more financially conservative than those who hadn’t experienced this blight of American history[12]. People who experienced serious losses in the 2001 or 2008 recessions are likely to have a similar attitude toward risk.
Risk Capacity
To put it simply, your risk capacity measures how much of a financial hit you can take without drastic effects on your quality of life. There are several ways to gauge your risk capacity, but we will defer to J. Concannon[13] and say that there are three main factors to take into consideration:
1. Time Horizon
Time horizon looks at how long you plan to leave your money invested.
The longer you intend to wait before liquidating your investments, the more aggressive you can afford to be. After all, since risky investments tend to be volatile, you want to counter that volatility with longevity and to give your investments ample time to correct any losses.
🤔 How can you figure out your time horizon?
Consider these factors.
Your Age
The older you are, the shorter your time horizon will be. After all, the objective of any investment is to improve your future quality of life in some way, but what is the purpose of improving your future quality of life when you are already 93 years old?
Also, you should be aware that age has a compounding effect.
👉 For instance, if you invest $15,000 at a 5.5% annual compounded return, your portfolio should be worth $33,487 after 15 years, assuming that you do not withdraw or add anything to it. So, 15 years will help you more than double your investment.
👉 If you leave that same $15,000 for 25 years, which is just an extra 10 years, your investment should be worth $57,200, quadrupling your initial investment!
Where does that lead? The younger you are, the longer your time horizon may be. That leaves you in a position to take some risks. If you’re closer to the end of your time horizon you’ll be more concerned with protecting the gains you’ve made over your lifetime, and you’ll be less willing to take on risks.
Your Investment Objectives
👉 If you’re investing to have a nice little nest egg when you retire, then you already know your investment horizon.
👉 If you’re investing so that you can send your kids off to college, you also have a clear idea of how much time your investments have to grow.
The more time you have until these objectives arrive, the longer your time horizon will be.
💡 You might choose to have different investment portfolios, each to satisfy a certain objective. You may give these portfolios different risk levels based on when you expect to need them.
2. Your Resources and Needs
Any expenses you pay will come from one of four places: your paycheck, your savings, your insurance, or your investments. The size and reliability of those sources of income – and your likely needs – have an impact on your risk capacity.
Income is important enough to have its own category, but you’ll need to consider other factors as well:
- Upcoming liquidity needs. If you plan on making a large expenditure in the near future, then you want to guard your money and avoid risky investments. Large expenditures can include buying a house, medical expenses, or paying for college tuition.
- Your emergency fund. If you were to lose your job tomorrow, how long could you live off of your investments and emergency funds before you need to liquidate investments? How long would those investments last? If you have a large emergency fund, you can afford to be a more aggressive investor.
- Your insurance level. If you have a stable, reliable health insurance plan and you’re well covered against accidents and other potential unexpected events, you can afford to take on more risk.
If you have no immediate need for liquidity, you’re well insured, and you have a substantial emergency fund (most experts recommend 3 to 6 months of living expenses) your risk capacity will be relatively high. An investment loss is less likely to cause immediate distress. The probability of needing the money in your investment portfolio will be relatively low.
3. Your Income
Finally, you need to consider your income, the one you get from sweating 9 to 5. The size of your income affects your risk capacity.
👉 The larger your income is in relation to your expenses, the more aggressive your investments can be.
You also need to consider the stability of your income. For instance, while working at a company will guarantee you a stable paycheck at the end of every month, those of you who work as freelancers can never be certain that they will get paid come the first of the month.
Another factor to consider is the correlation between your paycheck and the overall stock market. Some people work in industries that rise and sink in perfect harmony with the tickers on Wall Street, in which case you should be cautious and avoid being overly aggressive. Those jobs could vanish in a serious stock market crash.
👉 If your job is least stable when your investments are at their lowest value, your risk capacity is affected.
Moreover, you need to ask yourself how fast you expect your paycheck to grow. If you can realistically predict that your paycheck should increase every year by 6%, you are in a much better position to be financially aggressive than someone who expects their paycheck to remain stagnant over the coming years.
Assessing Your Risk Tolearnce
Once you know your risk aversion and your risk capacity, you will be able to calculate your risk tolerance. That can be a complicated exercise because many of these factors are difficult to quantify. There are various methods of assessing risk tolerance. We’ve already mentioned the Grable and Lytton Risk Tolerance Score, which is widely used.
💡 If you’re not sure which risk tolerance calculator to use, try several. Look at the different results and compare them to your own perceptions of your risk tolerance. You need to be fully comfortable with the result, or it won’t be an effective tool.
We’ve developed our own risk tolerance calculator to help you quantify your risk. This calculator is different from all the others you will find because it takes into consideration not only your risk tolerance but also your risk capacity.
What To Do After You Calculate Your Risk Tolerance
Once you have calculated your risk tolerance you have to decide how that risk tolerance affects your investment choices.
Obviously, there can be other mediating factors, including your knowledge and expertise in the investment world. After all, if you know what you are doing, you are in a better position to assess the risk of a potential investment than someone who is a complete newbie.
📘 If you are new to investing start by reading our guide to investing for beginners and see where you can invest as a first-time investor in 2021.
Armed with your risk profile, you should be able to have a better idea of the type of investments that best suit you.
👉 If you are someone with a balanced risk profile, then you might want to place 40% of your portfolio into an index fund, 40% into bonds, 10% in a CD, and leave around 10% for speculation.
👉 If you are prepared to take on a higher level of risk, you may wish to devote more of your profile to individual stocks.
👉 If your risk profile is higher you may wish to take on more speculative investments.
Each person will find the best setup for them. If you’re not sure how to build an investment portfolio that suits your risk profile, consider consulting a professional financial advisor.
💡 If you’d like a less expensive alternative and your portfolio is relatively small, many online discount brokerages offer “robo-advisor” services that use algorithms to select investments that suit a client’s risk profile.
The Last Word on Risk
Finally, if you take away anything, then let it be this.
Jeff Bezos once asked Warren Buffet, “Your investment thesis is so simple. Why doesn’t everyone just copy you?”
The Oracle of Omaha replied, “Because nobody wants to get rich slow.”
So, remember: In both life and the stock market, there are few quick wins and many fast losses. Understanding your risk tolerance can help you avoid those fast losses and put you on the road to long-term gains.
