How Risk Averse Are You? A Guide to Smarter Investing

How Risk Averse Are You? A Guide to Smarter Investing

First it was cryptocurrencies, then meme stocks, then NFTs. Back in 2021 it felt like everyone was taking enormous risks in the hopes of striking it rich.

But even though the market is filled with high-risk opportunities, millions of investors still favor long-term, risk averse strategies. Just look at the over $8.1 trillion parked in index funds and ETFs as of December 2023. It’s clear that many people prefer stability over speculation.

Deciding whether to take the risk necessary for high-reward investments is tricky if you don’t have a plan. So, how can you figure out if you should be risk adverse? Let's break it down in a fun and easy way and determine the investment strategy that suits your age and comfort level.

What is Risk Averse?

Risk averse is a fancy way of saying you don’t want to take big risks. If you’re risk averse, you prefer investments that are less likely to lose money, even if that means your returns might be smaller. The goal is to keep your money safe and earn steady, reliable returns.

On the other hand, if you’re not risk averse, you’re more willing to take chances for the possibility of higher returns. This means you’re open to more volatile investments with the potential for greater gains. You may have some big losses, but you are willing (and able) to handle the financial setbacks.

Another way to describe a risk averse person is someone who does not have the ability or desire to continue working during a sharp and prolonged market downturn. This would include anyone who is retired or plans to retire imminently.

Now, when we talk about how “risk adverse” you are, what we're really talking about is risk tolerance.

What is Risk Tolerance?

Risk tolerance refers to an investor’s ability to endure the potential for loss in the pursuit of investment gains. It's influenced by several factors, including age, financial situation, investment goals, and emotional capacity for risk. Essentially, it’s about how much risk you’re comfortable taking on and how it aligns with your investment strategy.

In simple terms, risk is the chance you might lose money. High-risk investments, like stocks, NFTs, and cryptocurrencies, can fluctuate wildly in value. Conversely, low-risk investments, such as Equity Index Funds and Exchange-Traded Funds (ETFs), are more stable and less likely to lose value.

For example, while the stock market can go up or down in the short term, it generally gives good returns (around 7% per year) over the long run. So, for long-term investors, this conservative approach can be a successful choice.

On the other hand, high-risk investments, like NFTs, are prone to unpredictable fluctuation. In 2022, driven by the fall of speculative trading and cryptocurrency, the NFT market crashed. Most of the once ecstatic investors were left with next to nothing, as the NFT market dropped in volume by 97%. Now, in 2024, the headlines are proclaiming, “NFTs are Back!”

But it’s important to understand that risk tolerance isn’t just about winning or losing. The amount of time you plan to invest also plays a big role. If you’re younger, you can afford to take more risks and play the field for more significant returns. On the flip side, if you’re nearing retirement, you’ll want to stay more conservative and safe to protect your nest egg.

Knowing your risk tolerance allows you to confidently build your portfolio with your financial goals in mind instead of just following the crowd (or the lemmings over the cliff).

Quiz: Discover If You Are Risk Averse

Want to find out your risk tolerance? Here’s a quick quiz to help you figure out how much risk you’re comfortable with!

1. How Close Are You to Retirement?

  1. 0-5 years away
  2. 6-10 years away
  3. 10-20 years away
  4. 20+ years away

2. How Big is Your Emergency Fund?

  1. I don’t have one
  2. 1 month of savings
  3. 2-3 months of savings
  4. 3+ months of savings

3. What Kind of Investment Return Would You Prefer?

  1. A guaranteed return of 3%
  2. A 95% chance of a 7% return (5% chance of no return)
  3. A 75% chance of an 11% return (25% chance of no return)
  4. A 50% chance of a 25% return (50% chance of no return)

4. How Frequently Do You Gamble or Buy Lotto Tickets?

  1. Never
  2. Once a year
  3. Occasionally
  4. Regularly; I enjoy lotteries and gambling

5. How Would You Describe Your Money Skills?

  1. Not good
  2. Okay; I budget but don’t save much
  3. Pretty good; I save and invest regularly
  4. Excellent; I have a solid financial plan

What Your Results Mean

Tally up your answers to get a score between 5 and 20. This will give you a snapshot of your risk aversion and help you choose investments that fit your comfort level.

5-10: You’re a Cautious Investor (Low Risk Tolerance or “Risk Averse”)

You like to play it safe and prefer predictable investments. You’re likely close to retirement and value stability over potential high returns. Bonds, CDs, and low-cost index funds are your go-to options. You avoid high-risk investments and seek consistent, steady returns.

Typical Investments:

  • Bonds (government, corporate)
  • Certificates of Deposit (CDs)
  • High-yield savings accounts
  • Money market funds
  • Index funds and ETFs

11-15: You’re a Balanced Investor (Moderate Risk Tolerance)

You’re okay with taking on some risk but like to keep things balanced. You invest in a mix of stocks and safer assets like bonds. You aim for growth without going overboard on risk. A diversified portfolio and an emergency fund are your best friends.

Typical Investments:

  • Index funds, ETFs, mutual funds
  • Diversified stock portfolios
  • Real estate

16-20: You’re an Adventurous Investor (High Risk Tolerance)

You’re open to taking big risks for the chance of big rewards. You might dabble in cryptocurrencies, speculative stocks, and even day trading. While you seek high returns, you do your homework and invest wisely.

Typical Investments:

  • Index funds, ETFs, mutual funds
  • Cryptocurrencies
  • Speculative stocks

Who Should Consider a Risk Averse Approach?

Here are the groups of people for whom a conservative investment strategy is particularly advisable:

1. Retirees and Those Approaching Retirement

Why a Conservative Approach?:

  • Need for Financial Stability: Individuals nearing or in retirement depend on their savings for their daily expenses, so preserving capital is crucial.
  • Limited Recovery Time: With less time to recover from market downturns, protecting principal and securing a stable income becomes paramount.

Common Investments:

2. Individuals with Low Financial Security

Why a Conservative Approach?:

  • Limited Capacity for Loss: Those with modest savings or unstable income cannot afford to risk losing significant portions of their capital.
  • Liquidity Needs: Risk-averse investments often offer more liquidity, providing easier access to funds during emergencies.

Common Investments:

  • High-yield savings accounts
  • Money market funds
  • Government bonds

3. People with Short-Term Financial Goals

Why a Conservative Approach?:

  • Principal Protection: When saving for short-term objectives like a home purchase or upcoming tuition, it's crucial to safeguard your principal from market fluctuations.
  • Certainty of Funds: Knowing that your money will be available when needed provides peace of mind.

Common Investments:

  • Short-term bonds
  • Fixed deposits
  • Treasury bills

4. Individuals with Low Risk Tolerance

Why a Conservative Approach?:

  • Emotional Comfort: Individuals who naturally avoid risk or get anxious about market changes should avoid high-risk investments that could lead to stress or impulsive decisions.
  • Avoiding Panic: Risk averse investors are less likely to panic during market downturns, which helps them maintain a long-term investment strategy.

Common Investments:

  • Conservative mutual funds
  • Stable value funds
  • Blue-chip stocks

5. People with Fixed or Limited Income

Why a Conservative Approach?:

  • Income Dependence: Those who depend on a fixed income, such as pensioners, need investments that provide reliable returns without significant risk.
  • Focus on Regular Income: Low-risk investments often generate consistent income through interest or dividends.

Common Investments:

  • Dividend-paying stocks
  • Real estate investment trusts (REITs)
  • Fixed-income securities

6. New Investors or Those with Limited Knowledge

Why a Conservative Approach?:

  • Lack of Experience: New investors may not fully understand the complexities of high-risk investments and can benefit from starting with safer options.
  • Learning Curve: Beginning with low-risk investments allows new investors to learn about the market without the fear of substantial losses.

Common Investments:

  • Index funds
  • Target-date funds
  • Balanced mutual funds

Why Knowing Your Risk Tolerance is Important

Hopefully, you now know how risk averse you are and why. Understanding your risk tolerance is a critical step in making informed investment decisions. It helps you build a portfolio that matches your financial goals and emotional comfort, ensuring a smoother investment journey.

Your investment strategy should be based on your own risk tolerance rather than what your friends, parents, or the internet are doing.

Knowing your risk tolerance helps you avoid reckless decisions and keeps you balanced. All investments come with some risk, but the key is to find a comfortable balance between risk and reward that suits your unique needs.