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Why is it Important to Understand Your Risk Tolerance?

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As an investor, are you able to clearly define your risk tolerance?  If your answer is no, you are not alone!  An important part of the financial planning process is understanding and defining the ability to tolerate the risks inherent in investing.  Determining risk tolerance is critical when customizing an investment strategy that meets the needs of each individual.

What is risk tolerance?  Risk tolerance is a measure of willingness to accept higher risk or volatility in exchange for higher potential returns.  It is not a factor that is permanently determined and then left unevaluated for many years.  Risk tolerance is likely to change with age, income, knowledge, marital status, and other important life events, such as buying a home, paying for college, or retiring.

Categories of Risk Tolerance

While there are many different terms and subcategories utilized to define an investor’s risk profile, the three most commonly referenced tolerance levels are as follows:

  1. An aggressive investor is willing to use high-risk strategies in the quest for higher returns.  However, an aggressive investor must also be able to withstand substantial fluctuations in account value.
  2. A moderate investor believes in balancing portfolio risks through asset allocation and diversification among many different investments and strategies.  Moderate investors also diversify accounts by risk level, including some relatively low-risk choices along with a few higher-risk options.
  3. A conservative investor is willing to accept lower returns for the safety of their capital.  Investments often include CDs, bonds, cash, and money market accounts.

After reading through the profiles, you might have identified with one risk profile, or perhaps a combination of all three.  It is important to remember that risk tolerance is a measure of how much risk you can handle, but that is not necessarily the same as the appropriate amount of risk you should take.  A discussion of risk tolerance should also include an understanding of the terms risk perception and risk composure.  Risk perception identifies how an individual perceives risk and can be based on many factors, including current mood, past experiences, current market conditions, and recent performance of a particular asset class.  For example, it is common for an individual’s tolerance for risk to increase as overall market performance increases.  In turn, as market performance decreases, so does the willingness to take risk.  Risk composure describes how an individual will actually behave when faced with a financial loss.  Reflecting on behaviors exhibited during a previous market downturn can be one of the best predictors of the true tolerance for risk.

The advisors at Wisdom Wealth Strategies take pride in understanding your specific situation and personal risk preference, and we work with you to create a tailored plan that matches your goals, time horizon, and risk tolerance.

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