What Is Risk Tolerance, And Why Does It Matter?

One of the most important things to understand about yourself when it comes to finances and investing is your risk tolerance.

Your risk tolerance is basically a measure of how much risk you can handle.  This includes your financial ability to handle risk, as well as your emotional ability to understand risk.

You need to know how much you can afford to lose – and the way you react emotionally to uncertainty and possible setbacks.

Financial and Emotional Risk Tolerance

Understanding financial risk tolerance is fairly straightforward.  You just need to understand how much money you can afford to lose.  If you are investing, you need to know whether or not your finances could handle it if you lost your investment.

This also includes whether or not you can handle having the money tied up somewhere.  If you can’t afford to have $5,000 wrapped up in a GIC for five years, that’s something you need to understand about yourself as well.

Emotional risk tolerance focuses more on how you are holding up during times of uncertainty and volatility, as well as whether or not you become excessively exuberant in times of growth.

If you are concerned about wide swings in the financial markets, it might not make sense to invest in an asset considered risky; otherwise, you will find yourself stressed all the time, and your relationships could suffer.

Don’t just look at your financial risk tolerance when deciding what to do with your money.  Also consider your emotional state, and whether or not you are emotionally ready to handle a certain level of risk.

Make Better Financial Decisions When You Know Yourself

Understanding your personality, and how you handle risk, can help you make better financial decisions.  If you want to get out of debt, but know you run the risk of abandoning your plan, you can use credit counselling services to help you stay on track.

If you know that you are likely to trade too often as an investor, you can look into an automatic investment plan that helps you stay the course with dollar cost averaging.

Knowing your risk tolerance helps you as well.  If you know that you can’t handle a lot of risk in your portfolio, you can gravitate toward less risky investments, like bonds and index funds.

If you know that you can handle the risk, and you want a bigger chance of growth, that’s a signal that you can expand to riskier assets, such as commodities and currencies.

Think about how you react to risk, and think about how much money you have available to you – and the consequences if you lose it.  Be honest with yourself. If you have a partner, discuss your financial with him or her.

It’s important to understand how much risk you can take, whether you are making a purchase with your credit card, or whether you are hoping to invest in the next big company.  Know what you can handle, and make decisions based on that reality.

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