Posted by Mike Smith :: August 30, 2007 @ 7:25 amI have always considered the tradeoff between risk and reward to be the most fundamental principle in savings and investment. Knowing how much risk you can handle, your risk tolerance, will help you to set realistic goals for your financial achievements. In fact, your desires for your finances may dictate the level of risk you are willing to take.
One of the key components of risk tolerance is time. As a general rule, the more time you have before you want to reap your reward, the more risk you can take on. Risk tolerance is generally discussed with regard to retirement planning, but a more intermediate goal may be appropriate. For example, you may be planning to send a child to college a few years from now, and that could set your window of time for planning purposes.
The reason that people can generally take on more risk with more time is that if things don’t go according to plan, they will have time to make adjustments to their plan in the hopes of still reaching their goal. People also take on risk to absorb volatility in the performance of instruments in their overall investment portfolio.
A second factor in determining your risk tolerance is your personality. If taking on more risk will cause you considerable stress and anxiety, then that alone may cause you to shy away from the greater returns that may accompany the risk. If you are constantly watching and worrying about the path you’re on, then you may find yourself considering deviating from your plan at the first sign of trouble.
While you should always stay on top of your plan so that you can intervene if necessary, you also need to give any plan of action time to succeed as well. Changing your plan frequently, particularly if you only do so because of a temporary setback, may make reaching your goals even more difficult.
There are many calculators available to help you gauge your risk tolerance. Most are geared towards retirement or stock allocations, but I like the one on MSN Money. While its results do tend to include investment guidance as well, it also provides insight into your mindset towards risk.
Whether you choose to use an online calculator, or just ask yourself questions to gauge your risk tolerance, this is an important exercise. You may find renewed happiness in your financial plans by finding your optimal level of risk while staying on course to meet your goals as quickly as possible.
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