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What is time horizon and risk tolerance?

| May 08, 2018
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In a lot of my posts, when I reference investing according to your risk tolerance and time horizon? Do you know what I mean by that?

As many of you probably know, the finance and investment industry is heavily regulated in order to protect consumers. Now I am 100% for protecting consumers, but this, for lack of a better word, forces us to give partial advice on blogs like this one.

When I say, invest according to your own risk tolerance and time horizon, it's because I can't give blanket recommendations to my audience and therefore, have to say this line in order to stay compliant.

Again, I am not upset that I have to do this and I am happy our regulators go to such lengths to protect people.

With that said, let me explain what these two things mean.

Risk Tolerance

This is exactly what it sounds like. How comfortable are you with risk? The general gauge is to use a six-month period and to ask you how much you would be willing to lose during that period until you lose your mind.

If you are only comfortable with losing 10%, then you would have a low tolerance for risk. If your number is more like 90%, then you are very tolerant to risk.

Two quick statistics for you about market downturns. Historically, there has been a downturn of 10% (a correction) about every year and there has been a downturn of 20% (a bear market) about every 3.5 years. If you invest in the stock market, you have to stomach a certain amount of volatility1 and risk.

Generally speaking, people who have witnessed and felt (they had money invested) severe down markets (i.e. 2008, 2000-2001, 1987) can be far less tolerant to risk after the event because they've seen what can happen to their money in such a short period of time. This is not always the case, however.

Another general rule is the younger you are, the more tolerant to risk you should be because you have a lot more time to recoup any losses. Alternatively, when you are near or in retirement, you should be more conservative because your ability to earn and "ride out" any tough times will decrease. Again, not in all cases.

Time Horizon

Time horizon is how long you have to invest. How soon do you need the money? Normally, the sooner you need the money, the less risk you should take. If you are saving up for a down payment on a house and you need the money in two years, keep that money in a savings account.

Your odds of increasing your money in the stock market enough to make a difference is small in that period of time, but you could lose that money quite quickly if the market reverses.

Regards to young people compared to those in or near retirement, people just now entering the workforce should be able to invest for a very long time, so they can be aggressive and still be able to recoup any losses they incur, but those now retiring should take fewer risks in order to preserve what they have saved thus far.

One more time, this is not the same in all cases. Your particular circumstances will warrant a different tolerance to risk and a different time horizon.

Conclusion

These two items will determine what investments are suitable for you. By examing your tolerance to risk and your time horizon, you can determine what investments are appropriate for you and how aggressive or conservative you should be.

Note: All investments have risk, including loss of principal. This article was written for informational purposes only and should not be considered personal advice. Do not make decisions based solely on what you read or hear.


1 - Volatility - The term for how much and how often a market goes up and down. This last month (February) was the most volatile one we have seen in about 1 1/2 years.

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