How to Evaluate Your Risk Tolerance

How determining your risk preference can make you a better investor.

By + More

SmarterInvestor_Holsopple.jpg
Scott Holsopple
Investing is such a reactionary event for some people that it becomes second nature to make changes based on the latest news or story told around the water cooler. People believe that's the fastest way to make a buck.

Not that making a buck is a bad thing—quite the contrary.

[In Pictures: 6 Numbers Every Investor Should Follow.]

The issue is that very few people make money by investing based on the latest headline or a passing comment at work. Investing takes time, patience, and delving into the details to make sure you're getting a fair deal. Most of us, however, aren't interested in putting aside the time and doing it right. We want the instant gratification making a change in our portfolio gives us—that short-term feeling of taking control of the situation.

How do you overcome the need to take action based on a gut reaction when it comes to your long-term savings? You do a personality assessment.

Ask yourself these basic questions, and don't try to fool yourself with the answers you think you should have. There is no "right" answer. It's in your best interest to be truthful.

1. What is your tolerance for negative investment performance?

2. How would you feel if the market and your account lost 20 percent of its value in six months?

3. How likely are you to change the answers to these questions if there are large swings in the market?

Once you've answered the questions, you may want to ask someone who knows you well to answer the same questions on your behalf. Having a third party give their opinion about how they think you should respond will help you see the answers from a different perspective. Maybe you've felt all along that you are an aggressive investor, but your spouse sees the worry in your eye with every market fluctuation. Having that type of assessment should put you closer to a real evaluation.

[See What the Latest Fed Policy Means for Your Money.]

Now compare your answers and the answers from your third party. Were you truthful? Were there any surprises?

Getting answers to these questions is the start of determining your risk preference: conservative, moderate, aggressive, or somewhere in between. If your answers indicate you would have a negative reaction to downward trends, you may have more conservative investing tendencies. If you're more tolerant of the markets' ups and downs, then you could be considered more aggressive.

If the outcome points to you being a more conservative investor, you'll most likely have more bonds and liquid assets, like a money market fund. Those who slide toward the aggressive investing side of the scale would have more stocks rounding out their portfolio. There will most likely be some cross-over between asset classes regardless of your investing style.

The key is to start with the base knowledge of who you really are as an investor. Then you can build your portfolio based on the facts. There are plenty of asset allocation calculators available to give you a more in-depth look at your investing personality.

[See 50 Best Funds for the Everyday Investor.]

The next step is to build a list of investment options that will fit in the right asset categories. You'll be less likely to want to make changes on the fly if you've created a solid plan. Your comfort level with your investment choices will grow. The news and watercooler talk will soon be just that for you—the news and talk, not your investment plan.

It is normal to have feelings of uncertainty about our assets when the market seems out of control. And it is normal to want to do something to gain control of a seemingly off-the-rails freight train. But if you take a few minutes up front to put a plan in to place, you'll be less likely to react every time a headline catches your eye.

Scott Holsopple is the president and CEO of Smart401k, offering easy-to-use, cost effective 401(k) advice and solutions for the every-day investor. His advice has been featured on various news outlets including FOX Business, USA Today, and The Wall Street Journal. Keep tabs on Scott on Twitter and Facebook.