Understanding your risk tolerance helps you make investments that align with your preferences and goals. (Credit: Shutterstock)
Financial freedom requires a clear understanding of how to make money work for you. Learning how to invest is crucial to building wealth in the long run. The first step is gauging your risk tolerance. Are you able and willing to take on the level of risk that comes with different asset classes, such as equities (stocks), fixed income (bonds), real estate and cash?
Understanding your risk tolerance is part of creating your investment strategy. It also shapes your portfolio's makeup, the collection of assets you choose to invest in. Here's a guide to determining your level of risk tolerance.
Risk tolerance factors
Risk tolerance is based on two factors. The first is the willingness to take a risk, which depends on personality. The second is the ability to take on the risk, which relies on objective indicators like net worth, savings versus living expenses and sources of income.
Risk tolerance also takes investment time horizon, predictability and liquidity into account.
Typically, the longer your time horizon, the more risk you can take, as you can wait to recover any short-term losses. The time horizon based on risk tolerance levels can look like this:
- Aggressive: 10+ years of time horizon
- Moderate: 5 to 10 years
- Conservative 0 to 5 years
A general rule of thumb is subtracting your age from 100 to get the percentage of assets to allocate to stocks. So, if you're 30 years old, about 70 per cent of your portfolio should be in stocks. This calculation can also be adjusted based on risk tolerance and whether you have a stable and diversified source of income.
Risk in finance is determined by the asset's price volatility, which depends on timing and the amount of cash flow.
Fixed income investments like government bonds have low price volatility as the amount and timing of cash flow are known in advance. They are contractual obligations with pre-defined timing (usually quarterly) and a set percentage (also called coupon rate). Upon maturity, the investor will receive 100 per cent of the principal.
Equities or stocks have a higher risk than bonds as they are an ownership stake in a company. As a result, the stock price can fluctuate massively depending on the economic cycle and the business' trajectory.
How quickly the asset can be converted into cash usually depends on how big the trading volume is. The more buyers and sellers there are for any instrument, the greater its liquidity. In general, fixed income, especially in the form of government bonds, is the most liquid listed security. Shares in large enterprises are also typically highly liquid, but their liquidity is less than that of government bonds. In contrast, small to medium-sized companies are less liquid and exiting your investment during times of market distress could be difficult.
What is your comfort level
Risk tolerance considers your comfort level in taking losses to achieve a target return. (Credit: Shutterstock)
We can divide investors into three groups based on how much risk they can tolerate: aggressive, moderate and conservative. You may experience all three levels of risk tolerance as you enter new stages of life.
Aggressive investors prioritise the growth of their capital. The majority, if not all, of their portfolio would be in assets like stocks, real estate or even cryptocurrencies. These investors can afford to take more risks given their long-time horizon (10+ years).
Moderate investors have a shorter time horizon of around five to 10 years. They will seek a balance between predictability (bonds) and growth (stocks). The exact allocation will differ, but the portion for bonds will generally be more sizeable (approximately 40 to 60 per cent) than it would be for more aggressive investors.
Conservative investors have short time frames (zero to five years). These investors are typically retirees with no other source of income. Thus, they get living expenses from their portfolio and other incidentals like emergencies. Their priority is the predictability of returns rather than the growth of their assets.
Ask an investment or financial planner about savings insurance that provides a twofold function: income and protection in the future.
Check your ability to take risk
Your income, expenses, relationship status and personality affect your risk tolerance. (Credit: Shutterstock)
Think carefully about how much risk you can objectively and financially afford. This should be the deciding factor for your readiness to invest. You can "afford" the risk if you can regularly contribute to your investment portfolio, won't need to dip into it in the near future and are equipped to handle potential losses.
Risk tolerance can change over time. Keep these questions in mind as you weigh your approach to investing:
- Financial goals: what are you saving for (house, car, family vacation, higher education)?
- Time horizon: how many years do you need to invest to achieve your financial goal?
- Age: what is your time horizon?
Determining your risk tolerance requires research, reflection and expert opinion. Work with a professional financial advisor to help you determine your profile better and point you in the right direction.
You can achieve financial independence with a solid money management foundation. Watch as finance experts Anna Haotanto and Lachlan Campbell of the AIA Voices community share tips you can do today to achieve financial wellness in the future.
AIA Voices is a community of influential and educational voices from around Asia to talk about life, health and wellness. A platform to educate, motivate and inspire people to make positive behavioural changes on their health and wellness journey. Providing an opportunity for communities across Asia to connect, collaborate, and learn from each other. Designed to drive AIA One Billion, our ambition to engage a billion people to live Healthier, Longer, Better Lives by 2030.
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ResearchGate. 2020. Determinants of Financial Risk Tolerance and its influence on Investment decisions. [online] [Accessed on 11 August 2022]
Sage Journals. 2020. Financial Literacy and Financial Risk Tolerance of Individual Investors: Multinomial Logistic Regression Approach. [online] [Accessed on 11 August 2022]