LEARN MORE ABOUT RISK TOLERANCE
Risk Tolerance by Timeframe
An often repeated cliché is that which is being referred to as age-based risk tolerance. It is conventional wisdom that states a younger investor has a longer term time horizon when it comes to the need for investments and thus he or she can take on more risks.
Following this logic, an older person has a shorter investment horizon, especially once that person is retired. He or she would have lower risk tolerance. Although this may be true in general, there are certainly a number of other considerations that come into play.
First you need to consider the investment. When will you need the funds? If the time horizon is relatively short, risk tolerance should shift to be more conservative. For longer term investments, there is room for more aggressive investing.
Net worth and available risk capital should be important considerations when determining risk tolerance. Net worth is simply your assets minus your liabilities. Risk capital is money available to invest or trade that will not affect your lifestyle if lost. This should be defined as liquid capital or the capital that can easily be converted into cash.
Thus, you as an investor or trader with a high net worth can take on more risks. If your investment or trade makes up a smaller percentage of your overall net worth, then your risk tolerance can be more aggressive.
Unfortunately, those with little net worth or with limited risk capital are often attracted to riskier investments such as futures or options because of the possibility of quick, easy, and large profits. The problem with this is that when you are trading with the rent, it’s quite difficult to have your head in the game. Additionally, when you take on more risks with little risk capital, you can be forced out of a position too early.
On the flip side, if an investor with small risk capital using limited or defined risk instruments goes south, it may not take that person long to recover. You can compare this with the high net-worth trader who puts everything into one risky trade and loses. You can find that this trader will take much longer to recover.
Understand your investment objectives.
Your investment objectives must also be considered when calculating how much risk can be assumed. If you are saving money for your child’s college education or your retirement, how much risk do you want to take with those funds? Meanwhile, more risk could be taken if you are using true risk capital or disposable income to attempt to earn extra income.
Further, some people appear quite all right with using retirement funds to trade riskier instruments. If you are doing this for the purpose of sheltering the trades from tax exposure, like trading futures in an IRA, you have to make sure that you fully understand what you are doing.
This kind of strategy may be okay if you are already experienced with trading futures, using only a portion of your IRA funds for this purpose, and are not risking your ability to retire on a single trade.