Risk tolerance is a buzzword used by financial planners and investment advisors to shield themselves from liabilities in case of failure. Potential clients are always asked to fill out a risk tolerance questionnaire to ascertain the proper mindset that clients bring to the table so that a suitable portfolio can be formulated to match the client’s goals and needs. Really? How to measure your investment risk tolerance is a task that should be performed by the clients themselves so that they can make an informed decision regarding the investment(s) recommended.
- Without a doubt, you probably filled out that questionnaire without giving it much thought either.
- To test this theory, take a few free risk tolerance tests that are available online and do this. Answer all the questions in the most risk averse manner possible, but indicate that you have a very long time horizon. Most likely, you will be assessed as either risk neutral, or even aggressive. The reason for this is that, according to theory at least, longer time horizons typically infer a higher risk tolerance level, as you have more time to make up for losses.
- A good sign that your personal investment planner or advisor cares is when the person actually takes time to verbally ask questions and formally interview you to measure your investment risk tolerance, instead of just relying on a questionnaire. To be truthful, there are risk tolerance questionnaires that actually serve their purpose; however, these tend to be quite expensive, therefore cookie cutter questionnaires are mostly used.
- Within the concept of risk tolerance, risk perception is often confused with risk capacity. Risk perception refers to how risky investors perceive a particular investment to be, whereas risk capacity refers to the ability to absorb losses. Most investment planners tend to focus on the latter rather on the former.
- Since emotions can play an outsized role in investment decisions, investors themselves are in a better position to discern the viability of any particular investment suggested by financial planners.
- Paradoxes exist throughout the world; for example, risk taking is very much admired in society, as it is associated with success, but most people are actually risk averse. This is not to say that most people are timid regarding financial investments; however, it is just human nature that dictates that deviating from the norm is generally not acceptable.
To sum it up, how to measure your investment risk tolerance should be viewed subjectively, and successful investors should always take a proactive approach even when dealing with their financial advisors.