There is no such thing as a risk-free investment — some risk is inevitable, whether you’re investing in stocks, bonds, real estate or otherwise. What you can control, though, is how you approach and cope with investment risk. Your risk tolerance is essentially the degree of variability you’re willing to withstand on the market.

Some might take a bold approach, unmoved by risk, while others retreat at the slightest hint of volatility. Most of us fall somewhere in-between. Understanding your behavior as an investor is the first step to understanding your risk tolerance. Those with a high-risk tolerance are most often considered aggressive investors, whereas those with a lower risk tolerance are deemed moderate or conservative.

While investing your money is fairly commonplace, investment portfolios are unique from investor to investor and often hinge on risk tolerances. Several factors play into your risk tolerance, including the type of risk, the investment and your individual life circumstances.

What Types of Risk are There?

Before jumping into determining your risk tolerance, it is important to understand the varying types of risks an investor may encounter. Among them:

• Market risk – Investments can decline due to economic developments that reverberate across the market. When you invest in stocks, the market price of your shares may fall. Bonds, on the other hand, could decline because of changing interest rates.
• Liquidity risk – You might not be able to sell your investments at the price you expected.
• Concentration risk – Rather than holding a diversified portfolio, this type of risk occurs when money is concentrated in one type of investment.
• Credit risk – The possibility that the bond issuer will not be able to repay the interest and principal of your bonds at maturity is considered credit risk. 
• Reinvestment risk – When you reinvest a bond’s principal or income at a lower interest rate, you can face reinvestment risk and could potentially lose money.  
• Inflation risk – It’s possible that the value of your investments might not keep pace with inflation. Over time, this reduces your purchasing power.
• Horizon risk – Your investment timeline can be shortened due to an unforeseen event, like the loss of a job or a medical issue.
• Longevity risk – You could outlive your savings.
• Foreign investment risk – If you’re investing in foreign countries, you’re exposed to the volatility experienced by markets overseas.

Additionally, everyone faces the risk of unexpected life circumstances, including becoming disabled or passing away, which can greatly impact your investments and your family’s finances.
 

How Do I Evaluate My Own Investing Behavior?

A financial planner can help you determine what risk you’re willing to take with your investments. Oftentimes, planners will use a questionnaire to help uncover your risk tolerance and investing style. This assessment might include situational questions similar to the following:

Imagine in the last 6 months, the overall stock market lost 15% of its value. An individual stock you own also lost 15%. What do you do?

• Sell all of my shares
• Sell some of my shares
• Do nothing
• Buy more shares

Depending on the answers you give, the planner will develop a custom investment plan reflective of your risk tolerance and other considerations, such as your long-term financial goals. Having a solid and personalized investment plan in place can guide you in the right direction and helps you avoid losses.

What Else Should I Take Into Consideration?  

Beyond risk considerations, consider the difference between your investments that receive a daily valuation and those that are only valued upon sale. Don’t assume that all investments are traded on the stock or bond market — you may have some investments outside of that market and their daily values are not available. These types of investments can include REITs (Real Estate Investment Trusts) and BDCs (Business Development Corporations). These investments give a false sense of security because there is no apparent volatility. But these cannot be liquidated at will — you won’t know their true value until you sell them or there is a liquidity event.

 
Furthermore, don’t be fooled by the fickle nature of the market. When prices are high, we might feel really good about our investments and want to buy more. When they’re low, we’ll be discouraged and want to sell. Whether your instinct is telling you to buy or sell, getting the objective perspective and recommendations from a financial planner may be invaluable.

All-in-all, some risk is unavoidable to see considerable returns. Also keep in mind that your risk tolerance can change over time, as you adjust your goals and priorities. So, whether you’re repositioning your investments, want to adjust your investment style or are simply curious about the best way to design your personal investment portfolio, a financial planner can be an experienced guide.

Bill Kelso, CPA, CFP®, is a financial planner* at Pinnacle Financial Advisors, which assists individuals, families, and businesses with financial planning and wealth management in Sedona and the Verde Valley. He is a Registered Representative offering Securities through UNITED PLANNERS FINANCIAL SERVICES, Member: FINRA, SIPC. *Advisory Services offered through SEROS FINANCIAL, LLC. Pinnacle Financial Advisors, Seros Financial, and United Planners are independent companies.