5 Factors That Determine Your Investment Risk Tolerance

Ivan Skladchikov
May 7, 2020
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For most people, “risk” sounds like something 100% negative that a smart person should avoid or minimize at all costs. But if you are an investor, you’d better move from risk avoidance to risk management unless you are ready to miss many profit-making opportunities. Today, we will explain what investment risk tolerance is, with a focus on digital currencies.

Main Risks Investors Deal With

There are several major risks to manage:

  • Volatility
    Some assets are very volatile, meaning their value can vary significantly, depending on many factors. The best example is Bitcoin and other cryptocurrencies. Therefore, a crypto investor still runs a risk of losing a lot due to a sudden change in the market mood. On a brighter side, you can make more money.
  • Cyberattacks
    Hacking is a serious risk, especially when you deal with crypto assets. If your trading platform suffers a major security breach, you are very unlikely to retrieve your funds. To be fair, it’s not always the fault of an exchange — often, crypto users lose money just because they have been ignoring the basic safety rules. Or fell victims to frauds.
  • Social and political risks
    Sometimes the value of your investments depends on social and political changes. They can be beneficial or unfavorable. For example, the current cryptocurrency regulation varies greatly across countries and regions and its future is rather hard to predict. This legal unclarity and flexibility create additional risks — and additional opportunities.
  • Liquidity risks
    Low liquidity means that you are unable to sell your investment asset quickly and at a fair price. If you have no emergency fund and need money badly, you have to sell the asset at a lower price. In the worst case, when the liquidity is next to zero, you cannot find any buyers.
  • Concentration risks
    Focusing on a particular type of investment asset may be dangerous. It means you can lose a lot when this asset misbehaves. So, you’d better spread the risk across various kinds of assets, diversifying your investment portfolio. In simple terms, avoid storing all the eggs in a single basket, even if it looks sturdy.
  • Inflation risks
    It mostly refers to cash. Your money growth should outpace inflation. Otherwise, the value of your savings gets eroded over time. Every long-term investor should keep this in mind.
  • Unforeseen events
    These events vary from a job loss to a medical emergency. In this case, you may need to withdraw your funds to cover the related expenses. Sometimes, it’s not the best time for doing so. Say, the market price of your investment asset is rather low at the moment but you cannot wait until it grows. By the way, this is a popular excuse for not investing.
  • Life expectancy-related risks
    Older people who make a long-term investment run a risk of passing away before they start enjoying the fruits of their financial sacrifice.
High, moderate, and low-risk investments. Image source: The Tortoise Mindset

Investment Risk Tolerance: Definition

This term means your capacity to take investment risks without suffering great psychological discomfort and endangering the financial health of your household. This parameter depends on many things. Below, we will highlight the main 5 factors that affect it.

One of the benefits of investing early is the ability to take bigger risks. Image source: Quora

Factor 1: Your Time-Frame

Defining your investment time frame often goes hand in hand with life expectancy issues. An older investor, on average, has less time available. If you are in your 20s or early 30s, you can take bigger risks. First, you will have resources to recover from a potential loss, as you are going to work for the next 30 years or even longer. Second, you can wait till the project you have put your money into grows and matures.

If you have a different goal, ask yourself two questions: “When will I need this capital?” and “How much money do I want to have by this date?”
Then, adjust your investment risk tolerance to your goals and deadlines.

In a general case, a short-term investment means you should favor traditional assets (i.e. you have low risk tolerance). On the contrary, a long-term investment allows you to play with high-risk assets.

Factor 2: The Size of Your Risk Capital

The term refers to the amount of money you can afford to lose without putting the life-style of your family under threat. Normally, you use this amount for high-risk and high-reward investments. It sounds very obvious, but you cannot imagine how many people forget about this rule when someone shows them a quick way to riches. Just remember the recent cryptocurrency gold rush that lasted for a couple of years and finally left many people disappointed. Some of them invested their life savings or sold their apartments lured by the promise of quick multiple returns.

Let’s make it clear: it’s a very bad strategy even if the startup seems very promising. So, you should always be aware of the size of your risk capital and avoid increasing it on a whim. The bigger is your capital, the higher is your level of tolerance.

Some books for improving a beginner’s investment education. Image source: Wall Street Mojo

Factor 3: Your Experience

The level of experience is another important factor when it comes to evaluating your investment risk tolerance.

How long have you been in on the market? Are you a hobbyist or a pro? For beginners, it would be smart to act with caution. At this stage, it’s a bad idea to risk big amounts of money, no matter how rich you are. Start with accumulating enough experience through watching and learning. When you feel more confident, you may increase the size of your risk capital.

If you are a pro, you can deal with riskier assets and strategies unless your guts advise you otherwise.

Investment goals may vary from holiday to holiday house. Image source: Quote Master

Factor 5: Your Goals

The key question here is: “Can I afford to put my goal at risk?”
It’s logical that if you are investing for retirement, you should think twice before relying on high-risk assets for it. At least, don’t make them 100% responsible for the success.

If your dream is buying a Lambo by the age of 40, it’s a different thing. To fulfill this wish you can get involved with volatile assets. Just don’t forget about Factor 2 and read our Cryptocurrency Investment Guide for beginners.

Different types of investors and their behaviors. Image source: PNG Wings

Factor 5: Your Psychological Profile and Background

Tolerance means you are okay with something. The investment risks you take are not supposed to rob you of your sleep and appetite. So, don’t put yourself under the stress you cannot manage. 

Some people are naturally risk-averse, even if they have never faced hardships. This behavior can be rooted in their childhood, or culture, or early education, or some painful experience. Some persons feel very unhappy when things don’t go exactly as expected. In contrast, there are those who see investment as a game of chance and enjoy it.

The algorithm for assessing your risk appetite. Image source: Regions

Investment Risk Tolerance: Key Rules

In summary, here are the basic principles you should follow.

  • The returns you hope for are in direct proportion to the level of risk you should be ready to take.
  • The greater your profit expectations, the more likely you are to lose your investment, or a big part of it, in the short term.
  • Your investment goal and time-frame may reduce or increase your risk tolerance.
  • In general, a person can afford more risk with long-term investments and less risk with short-term ones.
  • The degree of risk should be emotionally comfortable for you. Among other factors, it depends on your psychological profile.
  • When evaluating the probability of emergencies, rely on statistical data and not on individual stories.

Last but not least, you should always remember that there are exceptions to general rules. Our goal was to make you aware of these key principles and not to offer personalized investment advice.

It takes a comprehensive view to make the right decision.

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