Determining Risk Tolerance

All investments involve risk. This is why you need to determine your risk tolerance before placing any trades. Since not all investments are the same, the amount of risk you are willing to take on can limit the products you are able to add to your portfolio and how much money you can afford to put into them. There's a lot that goes into determining your risk tolerance, so it's important to do your research and carefully evaluate your funds before making any decisions.

How can you figure out your risk tolerance level?

First, consider the goals you have for your investments and how much money you have to put towards any investments you want to include in your portfolio. There are three classes of risk tolerance: aggressive, moderate, or conservative. An aggressive investor can take on riskier investments with the potential to take heavy losses, as these investments also tend to have the possibility of yielding the highest returns. A moderate investor has a steadier approach, investing in slightly less risky products, likely profiting at a slower rate. A conservative investor can't handle high losses and will tend to steer clear of complex portfolios, illiquid investments, and products in which they might lose more than their principal.

To figure out which group you belong to, know what your short- and long-term goals are for your finances, how much you are looking to invest, and which products are suitable for your budget. Not only should you keep your income in mind, but also any other funds that you might receive. If you have or will soon inherit funds from a family member, you might be able to have a higher tolerance level. On the other hand, if you don't have much more than you are taking home each month, you might need a smaller portfolio, which will limit the amount of risk you can take. If you need help determining your level, try using an online calculator or discuss risk with a financial advisor.

There is no good or bad level of risk tolerance—whatever class works best for your unique circumstance is the only right choice. Additionally, it's necessary to note that your tolerance level is only your willingness to take on certain risk, and this is weighed solely on your personal evaluation.

What happens if you ignore risk tolerance?

If you start trading without considering your tolerance level for risk, you have a higher chance of suffering significant losses. By jumping straight into trading, you might not think as strategically about how much you want to invest. This can also lead you to potentially buy securities that may come with a high risk you didn't consider, or you could end up with a portfolio with minimal diversity, which would make it difficult to hedge against risk.

It's in your best interest to determine your risk tolerance carefully, and only allow yourself to take on the level of risk that is suitable for your budget. Realizing that you skipped this crucial step too late can do a lot of damage to your funds, investments, and ability to grow as an investor.

Can your risk tolerance change?

If you have a low risk tolerance now, you might feel discouraged, as your potential profits likely won't be as large as someone with a higher tolerance level. But, as your circumstances change, your tolerance level can as well. If you're early on in your career, there's a good chance you don't have as much extra funds to set aside for investments as someone with a decade of additional experience. As you progress in your professional life and see your income increase, you can reevaluate your risk tolerance and choose to increase your investment contributions or take on riskier products that might be more volatile than what you currently have in your portfolio. But, it's important to allow this to happen naturally. There's no way to guarantee profit with any investment no matter how high your risk tolerance is, so you shouldn't be willing to take on risk at a higher level than you can truly handle. When the time comes that you're able to set higher amounts of money aside to put into your portfolio, that's when you can begin to think about increasing your risk tolerance.

Why does it matter?

Without knowing how much risk you can handle, you might find that you're losing more than you're able to afford. Even though having low risk tolerance can feel limiting, knowing what you can afford to lose can help you with loss acceptance and prevent you from making rash choices for your portfolio that might be a bad idea for you in the long run. As you grow, you'll be able to take on riskier investments to potentially make higher profits. Every investor has to start somewhere, and it's necessary to take careful steps to get to the place you want to be in order to limit making mistakes with consequences.

Disclaimer: Securities trading is offered to self-directed customers by Webull Financial LLC, member SIPC, FINRA. All investments involve risk, including the possible loss of principal. You should consider your investment objectives carefully before investing. This is not a recommendation, investment advice, or a solicitation for the purchase or sale of a security. Additional info: webull.com/policy