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Understanding your risk tolerance in investing

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Arthur Rudolph, the scientist who managed the development of the Saturn V rocket for its first mission to the moon, described risk tolerance perfectly: “You want a valve that doesn’t leak and you try everything possible to develop one. But the real world provides you with a leaky valve. You have to determine how much leaking you can tolerate.”

Before developing your investment strategy, you need to be sure about the amount of risk you can tolerate, regardless of the type of investment you are considering.

Whether you want to invest in a retirement annuity, living annuity, pension fund or a small share portfolio, you should only proceed once you have determined your risk tolerance.

In practice, however, it’s not quite that simple, as there are various factors that influence our risk tolerance.

For example: Visualise the best summer vacation possible at your favourite holiday spot.

Now visualise the same vacation while you are suffering from a severe case of the flu.

I doubt I need to say more about why this holiday suddenly doesn’t seem quite as great as you initially thought.

The reason is simply that the thought of being ill is having a negative effect on your emotions.

It is therefore extremely important that you analyse your risk tolerance in two ways.

The first is your emotional risk tolerance.

You may be so adversely affected by what you read in a newspaper on a specific day, or even by a short-term illness, that you see yourself as too conservative for your current investment portfolio.

As a result, you may restructure your long-term investments inappropriately.

Financial analysis may indicate that you are able to take more risk in your investment portfolio, but due to your emotional discomfort, you feel compelled to act more conservatively.

Secondly, you need to look at your financial risk tolerance, which is linked directly to your financial wellbeing.

You may have additional capital at your disposal that you do not need for any short- or long-term needs.

This will allow you to apply a riskier investment strategy.

The opposite may also be true. You may have a very high-risk tolerance, for example, but have limited funds in your retirement portfolio.

In this case, your financial risk tolerance would point to a more conservative strategy.

To determine your personal risk tolerance, we need to look at three main factors:

1. Risk capacity: This relates to your ability to tolerate losses. If you cannot afford to tolerate short-term losses in your portfolio, it would be wise to avoid high-risk investments altogether. 

This is an excerpt from an article that originally appeared in the 16 April 2015 edition of finweek. Buy and download the magazine here

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