🤨 How to Find Your Risk Tolerance

TLDR: Assessing your risk tolerance in financial planning goes beyond just your gut feel. Taking a more rational and intentional approach makes a lot more sense. Factors like age, commitments, and personal preferences all play a role. Be honest about stress tolerance and evaluate worst-case scenarios. Also weigh alternatives to determine a level that aligns with your comfort and goals. You’ll thank yourself later!

• ☣️ To Risk or Not to Risk

• 🤗 Your own Attitude

• 📈 More on Risk Premium

• 😎 The Chad Takeaway

No extreme is ever good.

But we sometimes act like investing is either “YOLO and bet the farm” or “do nothing and put money under the mattress”.

Taking extreme risks may sound like the stuff of Hollywood movies. The Chad who “risked it all” to start their business or go all-in on a stock.

But despite this romantic take, jumping heard first into a Hail Mary bet isn’t really the best way to build long-term wealth.

On the other hand, a completely conservative portfolio with zero tolerance to risk might not be the best option either.

So, what’s the correct answer?

Despite what anyone else might tell you, ultimately it is completely up to you to decide your level of risk. Some people may have a better taste and appetite for risk. Some may have a more cautious approach.

The catch is that the correct answer is different for every person. And that’s completely fine, as long as you find your own balance.

The art and science comes from understanding where risk comes from and making an informed and rational decision that aligns with your goals.

In addition to this “gut feel” there are a number of factors you have to take into consideration to make this informed decision.

This includes your age, your commitments and personal preferences.

Whether to indulge or not into risk depends on several factors that you should consider.

• Age: The unstoppable track of time is one that you should definitely consider. What’s your stage in life, family, and career. The obvious conclusion is that the younger you are, the more likely you are to be able to recover from a loss. But don’t take it to extremes! A generally accepted rule of thumb is the “100 minus your Age Rule”.
  
  This means that you invest your age (say you are 30) as a % in lower risk assets (like bonds, i.e. 30%) and the difference from 100% (i.e. 70%) in riskier things like stocks.

   

• Commitments: Of course, having people depending on you, such as children or parents, is a more than justifiable reason to have an aversion to risk. On the same way, financial commitments will undoubtedly hinder your wanting to make bolder choices.

   

• Assets and Income: You should always know which percentage of your wealth are you willing to sacrifice and lose. If an investment going south will dramatically affect your lifestyle, then obviously best avoid it. Ask yourself, if X asset or income source disappeared tomorrow, what would it mean to me? Would I have to go back to a job I hate, for example?

   

• Your reaction to risk: Ancestral Chad Lao Tzu said that the soldier that knows himself is worth double. Following on his words, take a deep introspection. Are you a naturally positive, or negative person? There’s no wrong answer here, but you should consider it when knowing how to face risks. If you are going to panic sell when an investment is in the red, then find a way to manage yourself in this arena, make these investments a small part of your portfolio or simply delegate to a qualified financial advisor.

Finance 101 will teach you that the levels of risk are usually proportional to the level of reward.

This in turned leads us to the concept of the Risk Premium.

This is the difference between an investment with a certain degree of risk against a risk-free rate of return like a US Government Treasury bond.

This calculation of a risk premium should be at the upfront of your investments, since it will help you decide which risks you are willing to take.

Risk Premium could be seen as a ‘hazard pay’ for our investments.

You can see it as the compensation a worker gets for performing a dangerous activity.

In a high interest rate environment (like today) the higher risk-free rate means that other riskier investments have to yield more to compensate for that risk.

So bear in mind when interest rates are low (which may happen again in the near future) the compensation for risky investments will also be lower.

And buying into those investments at that time may cause trouble in the future when interest rates rise.

Be honest with yourself. Realize how much stress can you sustain.

Understand how much risk you are willing to afford, specially on worst case scenarios.

Always ponder, what are the alternatives to taking a risk and will this change my life unncessarily? 

Don’t forget: Only you will fully know what grade of risk you are happy with. But use all the tools of your disposal to learn where you land in this respect.