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Investing your money is one of the most important ways you can improve your finances and build wealth. In fact, if you only focus on saving, and not investing, your cash to lose its value due to inflation, and as a result you could struggle to keep up with the cost of living.
But investing comes with its own set of challenges. When you put your money into the stock market, you could potentially lose some of your investment. Before you get started, you need to know how comfortable you are with the risks.
Risk tolerance is a measure of an investor's ability to comfortably stomach losses, and it's very different for everyone. This is why it's important to not just copy another person's investment portfolio — they may be more or less comfortable with riding out heavy losses compared to you.
Understanding your risk tolerance is an important first step in figuring out which stocks, bonds, funds and ETFs are right for you. Below, Select covers a few very important considerations to keep in mind when figuring out how much risk you can handle.
Figuring out your financial goals can help you determine how much time you have to grow your money, and thus how much risk you can take on with the assets you choose. You might want to ask yourself what you're saving for, when you hope to withdraw some or all of the money and how long you'll need the money to last.
Generally speaking, the longer your timeline, the more risk you can take on since your money would have more time to recover if there's a significant drop in the market. Let's say you want your investments to cover the cost of a down payment on a home. You can feel comfortable taking on more risk if you're not planning to withdraw the funds over the next five years. If you need the money sooner, you'll want to be more cautious with your cash.
Also keep in mind that your goals, and thus your risk tolerance, can also be tied to your financial security. You may feel more inclined to take on more risk if you have a stable income, little (or no) high-interest debt as well as some funds you've earmarked for discretionary spending. If you're not struggling to cover for all your monthly expenses, then you might not worry as much if your investments take a dip because you're not relying on that income.
In their book "Nudge: Improving Decisions About Health, Wealth and Happiness," Cass Sunstein and Richard Thaler describe loss aversion as a strong desire to stick with what you currently have because you don't want to risk taking on losses. In fact, humans are so loss averse that losing something makes us twice as miserable as gaining that same thing makes us happy. In other words, we would feel twice as upset if we lost $100 on an investment than we would if we gained $100 on the same investment.
With this in mind, think of risk tolerance in terms of your comfort with having a guaranteed result or a chance outcome. For example, would you prefer $1,000 in cash right now or the 50% chance of winning $5,000?
If you'd prefer to receive $1,000 right now, this could be an indicator that you have a lower risk tolerance because of your preference for a guaranteed outcome despite missing out on the chance to win a larger amount.
On the other hand, if you chose the chance to win $5,000, this could indicate a higher risk tolerance since you were willing to assume the risk of potentially taking home nothing for the chance at larger gains.
Of course, you'll also want to consider how taking on risky investments will make you feel on an emotional level. Does checking your brokerage account frequently and seeing numbers in the red stress you out? Are you easily jarred by dismal market news? Would losses make you feel inclined to divest from the asset much earlier than you intended? Keep these reactions in mind when deciding whether to make a riskier investment.
These reactions may also be a signal that you prefer a more hands-off investment approach where you don't need to be actively involved in deciding which assets to buy. Robo-advisors, like the ones offered by Betterment or Wealthfront, allow you to put your investments on autopilot. You can indicate your risk tolerance and the robo-advisors will rebalance your portfolio for you based on how much risk you want to assume, market conditions and other factors. This more removed approach to investing could help quell some of your stress if you have a lower risk tolerance and are afraid of making a mistake that could result in a loss.
Minimum deposit and balance
Minimum deposit and balance requirements may vary depending on the investment vehicle selected. For Betterment Digital Investing, $0 minimum balance; Premium Investing requires a $100,000 minimum balance
Fees may vary depending on the investment vehicle selected. For Betterment Digital Investing, 0.25% of your fund balance as an annual account fee; Premium Investing has a 0.40% annual fee
Up to one year of free management service with a qualifying deposit within 45 days of signup. Valid only for new individual investment accounts with Betterment LLC
Stocks, bonds, ETFs and cash
Betterment RetireGuide™ helps users plan for retirement
Minimum deposit and balance
Minimum deposit and balance requirements may vary depending on the investment vehicle selected. $500 minimum deposit for investment accounts
Fees may vary depending on the investment vehicle selected. Zero account, transfer, trading or commission fees (fund ratios may apply). Wealthfront annual management advisory fee is 0.25% of your account balance
Stocks, bonds, ETFs and cash. Additional asset classes to your portfolio include real estate, natural resources and dividend stocks
Offers free financial planning for college planning, retirement and homebuying
Your risk tolerance can have a huge impact on the way you invest your money. Everyone's risk tolerance is different but considering your goals, your comfort with a chance outcome and how market changes impact you on an emotional level can help you figure out how much risk you can tolerate.
And while robo-advisors may help quell a few investing fears by offering a more hands-off approach to your portfolio, always consider seeking advice from a financial professional in order to more adequately map out your approach to your money.