Determine Your Risk Tolerance
You need to understand how much risk you’re willing to take and which types of risk most worry you. Your risk tolerance (the degree of uncertainty you are willing to take on to achieve potentially greater rewards) is determined by a combination of factors, including your investment goals and experience, how much time you have to invest, your other financial resources and your “fear factor.”
Accurately gauging your risk tolerance can be tricky. A financial planner can help you assess where you stand. A financial planner might ask questions such as:
- Are you more concerned about losing money or losing purchasing power?
- How much money are you willing to lose?
- How worried do you think you would be in a severe market decline?
- What kinds of investments might keep you awake at night?
- Do you intend to track your investments daily (a possible indication of unease)?
- How varied do you want your portfolio to be?
Investment Pyramid: Risk/Return Trade-Offs
Investments at the top of the pyramid tend to be speculative and some also are illiquid (meaning they are harder to quickly convert into cash without loss of value). While they offer more potential reward, they also carry greater risks for loss of principal than investments at the base of the pyramid.
Less risky investments at the bottom of the pyramid are more liquid and offer stable (although lower) rates of return.