When it comes to building a solid and comprehensive financial plan, it's critical to get a sense of your tolerance for risk. Most tools that help you assess your risk, however, use relative simple metrics – your time horizon. But getting a handle on tolerance for risk requires much more data gathering and input than just one number – how long before you need your money. What's more, if you're married, it also includes the need to knowing your household's tolerance for risk.
Why is it important to understand your risk tolerance?
Many financial planners suggest that it helps you build an investment portfolio that is appropriate for you. Often, planners suggest your asset allocation, how much you invest in stocks, bonds and cash, is based on several factors, including your tolerance for risk. The other two factors being your investment objective and your time horizon.
Now, truth be told. There are many kinds of risk when it comes to investing. There's inflation risk, interest rate risk, and market risk to name but just a few. But more often than not, investors like you probably think most about market risk when it comes to building your portfolio. And very often, the existing tools that evaluate your risk tolerance – in other words, how much volatility are you willing to accept – will classify you as an aggressive, moderate or conservative investor.
What type of investor are you?
If you get classified as an aggressive investor, you'll likely end up with more of your assets allocated to stocks. If you're classified as a conservative investor, you'll likely end up with more of your assets allocated to bonds. And if you're classified as a moderate investor, you'll likely have assets evenly divided between stocks and bonds.
But the output of such tools is only as good as the information being put in. And if it's garbage in, it will be garbage out. In other words, it's quite possible that asset allocation might not accurately reflect your risk tolerance. And in that case, your portfolio might either be too risky or too conservative instead of just right.