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Know Your Risk Tolerance Level Before Investing

If we have learned nothing else from the recent economic crunch, it should be that we need to not only avoid making overly risky investment decisions ourselves, but avoid working with financial institutions that take excessive risks, as well. The recession was caused, in very great part, by institutions that became blinded by the prospects for a big win, while at the same time, failing to take responsibility for the losses that so often accompany taking ill-advised risks with investors’ money.
No matter the assurances given by an advisor or the regulatory safeguards in place, investing is a gamble, wherein even the supposedly fail-proof investment vehicles can perform poorly or even fail, costing investors hoped-for profits, or even the loss of their entire investment. In either case, making a mistake on an overly risky investment or one that is less risky, but pays a minuscule return, can deny the investor income from lost future investment opportunities. Here are a few items to consider in determining your personal risk tolerance level.

risk-indifference-curves-for-different-risk-tolerancesYour age

Younger individuals typically embrace greater risks in general than do older individuals, and for good reason. Just as a younger person tends to heal more readily from physical wounds than an older person, the younger investor is less likely to be devastated by a significant financial loss than his or her older counterpart, simply because the younger investor has more productive years ahead in which to make up for losses and “heal” his or her financial status. Even the loss of almost all of the young person’s savings lacks the potential to devastate his or her life, while the older investor, with fewer earning and investing years ahead, may never fully recover. For this reason, the younger investor is often more likely to invest primarily in stocks and annuities that are bound to the market and its greater fluctuations, while the older investor is more likely to focus on less risky bond-based vehicles with their small but steady earnings.

Your current financial state

The investor who holds sufficient liquid assets to offset any emergency expenditure with money to spare will naturally be in a better position to risk a portion of his or her assets, without experiencing too great an impact upon lifestyle, than will an individual whose assets are limited or highly leveraged and therefore not readily available. It is essential for the successful investor to know realistically how much he or she can afford to lose without suffering too badly.

risk-tolerance-11Your understanding of investment principles

Some people who appear to be quite conservative in their lifestyle, and who rarely take chances that could result in their suffering physical harm, will conversely take ill-advised financial risks. On the other hand, there are people who are literally adrenaline junkies, eager to engage in extreme, dangerous activities, yet who avoid taking even minimal risks in their investment strategies, for fear of losing everything. It is important for the investor to avoid both extremes, and invest in vehicles whose returns will at the very least stay ahead of inflation, while avoiding those investment “opportunities” that promise astronomical payouts, but too often fail completely.

Your current and projected lifestyle

For many investors, becoming a parent presents the first real epiphany that inspires a sea change in their investment priorities and risk tolerance. Dreams of owning high-performance motorcars or taking annual vacations in exotic locales tend to be pushed aside by more selfless priorities, such as providing the child with the best possible care and preparing for an increasingly expensive classical education. Even those individuals whose proclivity is to live in the moment should take the time and thought to develop an investment plan, both for the short term and well into the future, to better prepare themselves to meet their ever-evolving priorities.
Of course, none of the above criteria are static. As the circumstances of one’s life changes, so too will their investment priorities and, by extension, their risk tolerance. For that reason, as well as the need to keep abreast of changing political, market, and other financial conditions, it is essential that every element of the investment plan, and most certainly the investor’s risk tolerance, be re-evaluated on a regular basis. This should preferably be done with the guidance of a trusted professional financial advisor, who is required by law to fully assess his or her client’s attitude toward risk.

This article was written by Dividend Mantra. If you enjoyed this article, please subscribe to my feed [RSS]