In Coming to Grips with Risk, business expert witness Shelley Lee Boyce writes that "Your tolerance for risk is an important factor in how you allocate your investment portfolio among different investments."
While investments are subject to many different types of risk, risk tolerance typically refers to your ability to hold an investment when the return is either less than you expect or it declines in value. You should only assume a level of risk you are comfortable with, so you aren't tempted to sell an investment when it is at a low point.
There are at least two factors affecting your risk tolerance. One is the level of investment risk appropriate for you based on your personal situation. Key factors to consider include:
• Family situation - If you are married and in good health, you can probably assume more risk than someone going through a divorce or who has health problems.
• Age - Typically, you are less willing to assume risk as you age.
• Employment - Individuals with stable employment or whose spouse also earns an income will typically be able to assume more risk.
• Debt and liquidity - If you have sufficient liquid assets to weather temporary financial problems, you'll typically feel more able to take on risk.
• Insurance - If you have insurance to cover the major risks in life, including life, health, disability, and property insurance, you will probably feel more willing to assume more risk with your investments.
• Other investments - The current composition of your portfolio will affect how much additional risk you want to assume. If your portfolio already contains investments with significant risk, you might want to invest in more conservative investments. On the other hand, if your portfolio is primarily composed of conservative investments, you may want to take on more risk
The other element is your emotional tolerance for risk. Even if your personal situation indicates you could assume a high level of risk that may not be prudent if you don't feel comfortable with that risk. How you've reacted to the stock market fluctuations over the past few years should provide an indication of your emotional comfort with risk. Have you taken the fluctuations in stride or were you anxious about your portfolio's value? Did you frequently check your portfolio's value or did you only check occasionally? Were you tempted to sell all your stock investments or did you realize that downturns are just a normal part of the investing process? What would you do if the stock market started to decline substantially again? How long could you withstand a declining market before feeling compelled to see? After answering these questions, you should have a better feel for your emotional tolerance for risk.