By: Julio Perez, Fall 2017 Graduate Research Assistant
If you have reached out to a professional to help you set up your investment portfolio, you have already encountered this question. Hopefully, the professional also explained to you what this phrase means, but it doesn’t hurt to simplify.
I have already touched upon risk when discussing stocks and bonds, and the concept is simple: play big to win big. Your risk tolerance will determine what you will invest in and in what quantity. Of course, investing and stock trading is not gambling (unless you are throwing darts at the newspaper to decide your next business venture), and most investors have a personal interest in their next investment. If you have a higher risk tolerance, however, you are more willing to invest in new entities, or those which don’t have a high certainty of returning you a profit.
At one end of the spectrum are speculators, who invest in the market solely for a profit and mostly work off of hunches or rumors to pull in as big a profit margin as they can manage. More often than not, these speculators fail spectacularly and lose all their capital due to such investments. More on speculators in future blog posts.
The vast majority of investors are more moderate in their risks. A rule of thumb for risk tolerance is that younger people have a higher risk tolerance and older people have a lower risk tolerance. Why? Well, most people invest to be able to rely on a money fund at a later stage in their lives when they cannot work as hard to provide for themselves and their families. Thanks to the mystical wonder known as “compounding interest” (to be demystified in future posts), the sooner you start investing even a modest amount of money, the more you will accrue compared to someone investing just as much as you but who waited longer to start.
Therefore, if you are say, 21 years old, you might be open to investing in riskier yet carefully-picked-out investment instruments because time is on your side. Moreover, if your investments do fail, you have time to recoup your losses and reinvest in the nearby future. If, instead, you are 40 years old, you have less time on your side. Although you might be earning more than the 21-year-old, retirement is just around the corner, and you can’t afford to lose all your life earnings in risky investments. Therefore, your investments will be less risky, as you try to make a bit more money for retirement but not risk losing all you have accrued so far.
Therefore, a brief and apt translation for “Let’s assess your risk tolerance” would be: “How much time do you have to invest?”