When you read about investing, whether online or in a magazine, then you’ll often see mentioned that “you need risk tolerance” or “depending on your risk tolerance.” However, rarely do the authors explain what they mean by risk tolerance and why it is important.
So in this article we want to shed light on what risk tolerance is, if perhaps another term is more fitting and give you a fun test, with which you can find out your own risk tolerance. Let’s go!
What is risk tolerance?
When you invest money, then there is always an inherent risk of losing it. Depending on the kind of investment you make, this risk tends to be higher or lower. Compare these two options, for example:
- Leaving your money in the bank account (and earn 0.01% interest)
- Invest your money in the stock market (and make an average 6% returns)
Risk and return often go hand in hand, that’s why a “safe” investment like leaving your money in the bank account to earn interest yields less returns than the stock market.
Now, risk tolerance describes how much risk you think you can take. Many people don’t want to take risks at all when investing their money, which is totally fine. These people have a low-risk tolerance.
On the other hand, there are people who take the gamble with very risky and volatile assets like cryptocurrencies. They have a high-risk tolerance. And, of course, there’s everything in between.
Risk tolerance ≠ Ability to take risk
Risk tolerance is often a very theoretical, whereas investing is often driven by emotions (although everybody tells you to keep emotions out of the equation). It’s easy to say you have a high-risk tolerance and to invest in crypto when markets a roaring sky-high.
But if market come down, everything is in the red, then the emotions often take over, and it’s not that easy to sit through that period – given you have the conviction that markets will recover. Therefore, risk tolerance and the ultimate ability to take the risk once a difficult situation arises, are two very different animals.
Yet, the latter is almost impossible to gauge if everything is going smooth, hence why the risk tolerance is a better factor to assess.
The Quiz – 7 Questions to assess your risk tolerance
In the following there will be 7 different questions, each with three possible answers. Depending on your answer, you will collect a different number of points which will be used to determine if you’re a risk-taker or if you like to play it safe.
How much money do you have on the side?
- Up to 1 monthly salary
- 2 – 5 monthly salaries
- 6 or more monthly salaries
Imagine you invest into stocks. Now the price of the shares drops 40% in a short timeframe. How do you react?
- I sell all my shares immediately
- I wait to see how it develops first
- I buy more shares now because I have cheap entry prices now
How would your best friend describe you as a risk-taker?
- I avoid risk like a vampire the sun
- I’m okay taking risk after doing enough research
- They’d say I’m a gambler
If you were on a TV show and can pick your prize, which one would you choose?
- 1000 EUR in cash
- A 50% chance at winning 5000 EUR
- A 5% chance at winning 100,000 EUR
When you hear the word “risk”, what do you think of first?
Imagine you inherit money, let’s say 200,000 EUR, and you would have to invest the money. How would you invest it?
- Keep it in the bank account
- Invest into an index fund
- Create a portfolio that also includes riskier assets
Speaking about experience, how comfortable are you to invest your money in assets other than the bank account (e.g. stocks, P2P lending)?
- Not comfortable at all
- I’m okay with it
- Absolutely no problem and am looking forward to the opportunity
Now to evaluate, check which answers you gave. Each a) gives 1 point, each b) gives 2 points, and each c) gives three points. Add all the points together, and then look in the section below into what category you fall.
Up to 10 points – Your risk tolerance is non-existent
You’re not the type that likes to take risk, especially when it comes to money. You would rather play it safe, even if that means missing out on potential gains. It just gives you more peace of mind knowing that you will not lose anything.
If you’re okay with this assessment, then there’s nothing to change. But perhaps you’d like to be more open to risk. Then a first step could be informing yourself about different assets and creating an emergency fund, so you can stick through bad times without selling.
10 – 16 points – Taking risks is OK for you
You’re okay with taking risks, as long as it stays in a certain balance, and you know what you’re signing up for. Return rates are important for you, but it’s just as important that you are in charge of what is happening to your wealth and assets. Gambles with unforeseen outcomes are a No-go for you.
17 or more points – Risk is my middle name.
You don’t take risk, risk is a part of you. Maybe you’re also more confident because you’ve saved up a good chunk of money in your rainy day fund, so you can pay expenses with that if your investments don’t develop as expected.
If the risky part of your portfolio tends to get out of hand, how about limiting the total proportion of it to a certain percentage of your total wealth? Many people deliberately cap their crypto investments at 5% of their portfolio, so it doesn’t rip a hole in their portfolio. Or, on the other hand, get too greedy and don’t sell, so they rebalance it to stay in that realm.
We are curious! Share your risk tolerance level in the comments and if you are happy with it or would like to level up!