Contents
Stock Investing Basics
Types of Stock
Stock Indices
How to Determine Your Level of Risk Tolerance
How to Plan Your Stock Portfolio
How to Research Stocks
How to Buy and Sell Stocks
How to Manage Your Stock Portfolio
Stock Investing and Taxes
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How to Determine Your Level of Risk Tolerance
Risk tolerance refers to the amount of risk you personally feel comfortable taking on through your investments.
- Investors with high risk tolerance can stomach the short-term volatility of risky investments (such as emerging markets stocks) in exchange for the superior long-term returns that those investments may provide.
- Investors with low risk tolerance tend to focus on investments (such as value stocks) that limit volatility and provide a steady stream of income without the prospect of extraordinarily high returns over time.
Investing in stocks that don’t match your risk tolerance can result in serious financial problems. To avoid these crises and position yourself to gain the maximum benefit from your investments, you must first determine your risk tolerance and then build an investment plan and a stock portfolio based on it (see How to Plan Your Stock Portfolio). To determine your risk tolerance, assess the following:
- The amount of funds you have available
- Your time horizon
- Your life situation
- Your personal response to risk
Available Funds
Since stock investing involves such a high degree of risk in the short term, you should begin investing in stocks only after you’ve paid off high-interest debts, such as credit card balances, and have secured at least six months’ worth of emergency savings in case you lose your job or suffer some other unforeseen calamity. The amount of money you have available to invest once you’ve paid off debts and have saved an emergency fund impacts your risk tolerance:
- If you don’t have a substantial amount of money to invest, your risk tolerance is likely too low to justify investing in individual stocks. Instead, buy a mutual fund or ETF that tracks a major market index.
- If you do have a substantial amount of money to invest, don’t just assume that you should be buying individual stocks. Instead, buy individual stocks only if the other three factors involved in determining risk tolerance convince you that you can accept the risk. Having more money to invest does not necessarily mean you have a higher risk tolerance. For some investors, individual stocks are never the right choice.
Time Horizon
Your time horizon is the amount of time you have before you’ll need the money you’ve invested. For instance, a 25-year-old who plans not to sell his or her investments until age 65 has a 40-year time horizon.
Time horizon is not just a function of your age or the year when you expect to retire. For instance, a young investor hoping to grow his or her investment portfolio for the purpose of buying a home in three years has a short time horizon. To calculate your time horizon, then, you must first consider your financial goals.
How Time Horizon Impacts Risk Tolerance
Time horizon has a direct relationship to risk tolerance:
- The longer your time horizon, the greater your risk tolerance: short-term dips in the stock won’t affect you (since you won’t need the money in the short term).
- The shorter your time horizon, the lower your risk tolerance: your wealth will be harmed if a short-term dip in the stock price cuts into your investment just before you need the money to pay for retirement, a house, or anything else.
For investors, this relationship between time horizon and risk tolerance means the following:
- Long time horizons (10+ years): These investors should invest mostly for growth.
- Moderate time horizons (5–10 years): These investors should invest for income as well as growth.
- Short time horizon (1–5 years): These investors should invest almost entirely for income.
Life Situation
A major factor in your risk tolerance is whether you depend on the income provided by your investments. For instance:
- A person who is retired and has no other source of income other than that generated by investment is dependent on investment income.
- A person who has a secure job with a good salary that pays the bills and provides extra money for savings is not dependent on investment income.
Investors who depend on investment income have a low risk tolerance, since they can’t afford any interruption to that income. Investors not dependent on investment income have a higher risk tolerance, since they can accept short-term volatility in exchange for long-term returns.
Your Personal Response to Risk
In addition to the risk that you can accept financially, risk tolerance also includes how you feel, personally, about taking risks and losing money. You should always consider adjusting your risk tolerance based on your personal response to risk when buying stocks.
- If you avoid risk in everyday life or worry easily: Even if you have a long time horizon and a life situation that favors investing for growth, it still might be best for you to avoid buying high-risk stocks. In exchange for potentially lower returns, you’ll get the benefit of lower volatility and less stress.
- If you enjoy risk and don’t worry easily: You should feel comfortable investing for growth exclusively—assuming your time horizon and life situation support that high-risk approach.
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