The selection of one investment over another should not be limited to a gut instinct. For example, if you like Coke more than Pepsi, that by itself is not reason enough to buy Coca-Cola stock. A legitimate stock-picking criteria you should consider is risk tolerance.
There are several attributes that will determine your own level of risk tolerance:
1. Investment knowledge and experience
The first aspect of risk tolerance is your familiarity with a particular investment market. Most people know that the stock market is “risky” when the economic outlook is uncertain. Price volatility of the averages translates to volatility in individual stocks. But beyond that, if you have gone through market swings in the past and you know how to recognize market swings, you are better equipped to remain calm during volatile times. For example, you may realize that a big dip in a stock’s price is going to be temporary because that company is a leader in its industry and is also well-managed.
2. Income and asset levels
Your risk tolerance is also defined by how much money you earn and how much you have in your portfolio. If you earn very little and have a small portfolio with just a few different assets, you cannot afford a large loss. If you have a diversified portfolio that you have built up over many years, you also know that you can afford a loss in one issue, because it will not impact the entire portfolio.
3. Age and living circumstances
If you are a young investor, you can afford to take bigger market risks. With more time to go until retirement, you also have more time to rebuild after a loss. However, if you are going to retire in only a few years, you cannot afford big risks. The same restrictions apply to your living circumstances. A young single person is going to invest differently than a married couple with children and a mortgage.
4. Long-term investment goals
What are you saving toward? The range of possibilities includes retirement security, a child’s college education, or a desire to start your own business — or all of these. Your priorities determine your risk tolerance. A few priorities, such as retirement, are critical, whereas others (such as traveling around the world after retirement) are optional. The more critical an investment goal is, the less risk tolerance it can bear.
5. Personal preferences
Finally, those personal preferences (Coke versus Pepsi, for example) are also important. It may be something as simple as a product preference or as broad as a market attitude. Some people love stocks but hate real estate, others love mutual funds but hate stocks. The reasons are not as important as that personal “comfort zone.” To succeed as an investor, you need to be happy with your choices.
No investor is immune from the often irrational and emotional actions or reactions within the market. In fact, that’s what makes investing and trading interesting. However, it certainly improves your chances for a satisfying and profitable experience if you also understand why some investments are better choices for you. Risk tolerance is much more than just exposure to possible losses. It defines who you are as an investor.
Michael C. Thomsett is author of over 60 books, including Annual Reports 101 (Amacom Books Press), Trading with Candlesticks (FT Press) and the recently released new book, Getting Started in Stock Investing and Trading (John Wiley and Sons). He lives in Nashville, Tennessee and writes fulltime.