Stienemarié Bonsma-Potgieter, CFP® – Financial Planner

When it comes to planning your financial future, one important factor to consider is your risk tolerance. Simply put, risk tolerance is how comfortable you are with the possibility of losing money in the short term in order to achieve long-term financial goals. Some people are comfortable with taking more risks, while others prefer a more cautious approach where the up and down movement of capital is limited.

Three Main Risk Categories

There are generally three levels of risk tolerance, and each can play a role in shaping your financial plan:

• Conservative: With a conservative risk tolerance, you’re more likely to choose safe, stable investments. You prefer to avoid large losses, even if it means slower growth over time. Long-term growth is there for partly sacrificed for greater stability over the short term. Examples where a conservative approach also works well is for emergency funds or provision for expenses over the next 12-24 months.
• Moderate: A moderate risk tolerance means you’re willing to take some risks, but you still prefer a balanced approach. You might combine both low-risk and higher-risk investments to get a mix of safety and growth. This approach can work well for medium to long-term investments like retirement savings where inflation beating growth is very important without taking on too much volatility.
• Aggressive: If you have an aggressive risk tolerance, you’re comfortable taking bigger risks for the potential of higher returns. While the chance of losing money over the short term is higher, you’re focused on growing your wealth as much as possible over the long-term. This approach comes with increased volatility and risks and is ideal for investors with a long-term outlook that can sustain losses over the short term.

Risk Tolerance vs. Risk Capacity & Required Risk

Risk tolerance is about your comfort with risk, but there are other factors to consider: risk capacity and required risk. Risk capacity refers to how much risk you can actually afford to take based on your financial situation, goals, and time horizon. For example, someone may be comfortable taking risks, but they have a lot of short-term financial needs, their capacity for risk may be lower as they cannot afford their capital to lose any value over the short term. Required risk refers to the amount of risk you would need to take to give you the best chance of achieving your investment goals. Someone may have a very low risk tolerance but may need to take on some additional risk to meet financial goals.

It’s important to balance your risk tolerance, risk capacity and required risk when building a financial plan that aligns with your goals and situation.

Why It’s Important to Know Your Risk Tolerance

Understanding and carefully considering your risk tolerance and risk capacity can help you make better financial decisions. Here are some advantages:

• More tailored investments: By knowing your comfort level with risk, you can choose investments that fit your risk tolerance and long-term goals.
• Better peace of mind: When your financial plan matches your risk tolerance, you’re less likely to worry during market ups and downs.
• Long-term success: Taking the right amount of risk helps you grow your wealth while staying within your financial limits.
• Staying the course: By investing in line with your risk tolerance, you are more likely to stick to your financial plan and less likely to make rash, emotional decisions.

Your risk tolerance is an essential part of your financial plan. By understanding how much risk you’re comfortable with and balancing it with your long-term goals as well as capacity for risk, you can create a plan that works best for you. Taking the time to consider all of this can lead to more informed choices and a smoother journey toward achieving your financial goals.