Types of Risk Tolerance
Risk Tolerance vs Risk Capacity
Risk tolerance is your emotional fortitude to cope with market ups and downs and portfolio losses. When the market goes down, do you lose sleep at night? When the market goes up, do you get overly confident? If market movements, up or down, sends your body into a frenzy of emotions, whether positive (euphoria) or negative (fear), you have a very low risk tolerance. Later in this chapter I’ll present a simple questionnaire to help you determine a baseline for your risk tolerance.
Risk capacity is defined in a few different ways, but in this course, I define it as how much financial risk a person can afford to take. For example, if you have high risk tolerance and want to buy an expensive risky asset, do you have the money to actually make the purchase and absorb the loss if the trade goes the wrong way? After all, if you don’t have the money to invest, or to lose, your risk tolerance is meaningless.
Keep in mind, investing isn’t meant to be totally logical and devoid of emotions. If that were true, people would get bored and not participate. It’s fun to make good decisions with our money that impact our finances and our future in a positive way.
The ultimate goal is threefold; avoid major emotional ups and downs, not lose all your money, and make a profit. Without control of your risk tolerance and capacity, you might be tempted to borrow a bunch of money to make a margin trade or fall prey to a pump and dump scheme or FUD news. We’ll touch on these topics in the lesson on How to Sell Losers. To learn more about trading check-out the course on investing basics.
Types of Risk Tolerance
Generally, investors fall into one of these three categories when it comes to investment risk tolerance.
Aggressive risk tolerance (high risk): People with aggressive risk tolerance tend to keep their focus on maximizing returns during short-term time horizons. Their goal is high long-term gains by profiting from short-term market fluctuations. If this fits you, then you will likely you’re likely willing to ride the full rollercoaster of market volatility on a daily or weekly basis.
Typical high-risk investments:
- Individual stocks
- Forex (fiat currency) trading
- Lump sum investing strategy
Moderate risk tolerance (medium risk): This person balances potential risk and potential rewards over a mid-term time horizon. Their goal is to reduce risk over a period of months to years. This investor is often comfortable with short-term losses of principal as long as the long-term potential looks promising. In my opinion, swing traders who ride the bull markets up and then patiently wait for bear markets to pass, fit this profile.
Typical medium-risk investments:
- ETFs and Mutual Funds
- Dividend paying stocks
- Cryptocurrency staking
- Variable dollar cost averaging
Conservative risk tolerance (low risk): This person is only comfortable with a small amount of risk with the focus being on preserving capital over many years. Therefore, the overall goal is to minimize risk and reduce principal loss at all costs, even if that means receiving a lower return on investment over time.
Typical low-risk investments:
- Money market fund
- Certificate of Deposits
- Crypto interest accounts
- Dollar cost averaging
While the financial industry tends to use labels like conservative, moderate, or aggressive to describe risk in the context of investments and investors, those terms are subjective. What they mean to you may be different from what they mean to someone else.
It can put things into a better perspective thinking of potential gains and losses in terms of actual dollars. A 15% loss might not sound so bad, until you think of it in terms of cash. A portfolio that shrinks $10,000 one month and $8,500 the next might be too daunting for a low-risk investor.
What about Profit Tolerance?
What I’m about to teach you may sound strange but consider it carefully.
Have you thought about your tolerance for winning? Yes, you read that correctly. Do you have a plan for when your crypto portfolio goes up and you’re so excited you can’t see straight? For example, in 2017 during the crypto boom that caused bitcoin to go from $1,500 to $20,000 in a few months, many investors became millionaires because they invested their life savings. Some would say that was a poor decision. I disagree, so long as they recognize that was a risky gamble and they got lucky and won. Good for them! However, I wouldn’t recommend this as an investment strategy.
But here’s the problem. Many people became millionaires only on paper. Why? Because they didn’t sell. Many people, myself included, thought the meteoric rise was here to stay. I was dreaming about retirement back then but didn’t really know what to do once my cryptos went up so high. I thought maybe I could just live off my crypto holdings and not sell it back into cash. Big mistake. Crypto is too volatile. It took 3 years for prices to bounce back. We’re always taught how to handle our emotions when prices are falling, and our portfolios are losing money. But very seldom are we taught to manage our emotions when prices are rising. Volatility is a double-edged sword. It’s one of the beauties of crypto and one of the tragedies. Prices go way down, but they can also go way up!
One of the best ways to determine your risk tolerance before you start investing is to take a risk tolerance questionnaire. This type of questionnaire is used by financial advisers across the country when working with new clients. They are not specific to crypto and some of them have way too many questions, but I think a simplified questionnaire is still helpful. Here are links to a couple I think are good. They each have 10 questions for you to answer. At the end you’ll get a report showing your risk tolerance based on your answers. My risk tolerance is moderate.
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