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Key takeaways:
- Risk refers to the possibility of your investments performing below your expectations. Different investments carry different levels of risk.
- Your risk tolerance is how much risk you are willing to bear when it comes to investing. It involves understanding how you might respond to drastic swings in the market and your ability to stick to a plan during challenging periods.
- Your risk capacity is how much risk you can afford to take on. It’s based on factors such as your financial situation and how much time you have to invest.
- You are more likely to stay invested when you find the level of risk that’s right for you.
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From stocks to bonds, and everything in between – every investment comes with some level of risk. Risk refers to the possibility of your investments not performing in the way you expect them to. To some, that means losing money when the price of an investment changes. To others, it’s seeing your investment lose purchasing power because of inflation. No matter what risk may look like to you, it will play an important role in your investment decisions. Before you start investing, it is helpful to ask yourself some questions about risk.
First, you will want to understand your tolerance for risk. For example:
- How comfortable would you be with market volatility?
- How might you react to seeing your investments drop in value?
- Are you someone who embraces investment risk because it opens the door to more opportunity, or are you more risk averse – and likely to lose sleep when the market loses ground?
How risk tolerance changes the way you invest
Risk tolerance relates to your willingness to take on risk to achieve your goals. It’s based on your beliefs, your personality and your investment experience. Think of it as your mental and emotional ability to handle possible investment losses.
For example, if you are more comfortable with risk-, you may choose investments that offer faster growth and higher potential returns – even if it means your holdings may lose value at times. If you’re a risk-averse investor, the opposite is true. You would opt for investments that aim to ‘defend’ your investments against losses – even if it means you could potentially see lower returns.
Risk: Defensive Assets vs. Growth Assets
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Risk tolerance questionnaire
When it comes to your investments, risk means the possibility of losses.
You can choose investments that have a low risk of losses, but these tend to grow more slowly.
Take this quiz to find out how you feel about risk and what it means to you as an investor.
You are likely a conservative investor. You appear to have a lower appetite for risk.
You prefer to avoid drastic shifts in the value of your investments when markets move up and down.
To avoid potential losses, you may choose a more conservative portfolio made up of mostly lower-risk investments, such as bonds or cash.
You are likely a balanced investor. You appear to have a moderate appetite for risk.
You are comfortable with some shifts in the value of your investments, as long as they grow steadily over time.
You may choose a balanced and diversified mix of different investments (cash, bonds and stocks).
This approach can help reduce risk and smooth out your returns over the long term.
You are likely a growth investor. You appear to have a larger appetite for risk.
Market ups and downs do not unnerve you as you pursue higher potential returns.
You may choose growth-oriented investments that aim to beat the market and help you maximize long-term growth.
View our products designed for conservative investors
View our balanced funds and portfolio solutions
Read our article on rebalancing your asset allocation
Read our article on bond basics
Read our article on balancing returns and volatility
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How risk capacity changes the way you invest
Risk capacity is not based on your feelings about risk. It’s not even based on any specific investment. Instead, it relates to how much risk you can afford to take. And that has to do with your financial situation, as well as your age and the time you have to invest.
It is important to ask yourself how potential losses would affect your ability to reach your financial goals. For example:
-
Are you saving for your child’s education? How many years before they finish high school? Will you have time to make up any losses if you take more risk as an investor?
-
Are you close to retiring? How much have you saved? How will it affect your plans if your retirement fund drops 5 or 10% in value before you retire?
-
Is time on your side? Do you have many years to invest? Or will you need to take money out of your investment account soon?
Why time is an important consideration for risk capacity
The chart below shows the worst annualized returns of three different investment portfolios over different time periods: Conservative (low risk), Balanced (medium risk), and Aggressive Growth (high risk).
A longer time horizon has reduced the likelihood of poor outcomes. Worst annualized return of representative portfolios over various time periods
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- The longer you have to invest, the more time you have to make up for any losses along the way. Over time, markets generally recover from losses. Looking to the right-hand side of chart, you can see that over 30 years, even the worst return of a high-risk portfolio was 8.3% annualized. That’s good news if you have a long-term goal you’re saving for, such as retirement. This means you have a larger capacity to take on risk in your portfolio.
- But, you may not be able to tolerate that level of day-to-day movement even if your financial situation and time horizon say you can. You might still opt for a lower-risk option that matches your tolerance.
- The opposite is true if you have a shorter time to invest. Now let’s say you have a nearer-term goal of buying a home in the next year. You now have less time to make up for any losses and so cannot afford to see a 12% drop in your investments, let alone an over 30% drop.
- In this case, your risk capacity dictates that you may want to opt for more conservative, low-risk investments - even if you think you could handle the emotions that come with losses.
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Risk capacity questionnaire
When making investment decisions, consider your overall financial picture, including the time you have to invest. To begin thinking about your risk capacity, answer the following questions.
Based on your answers, the impact of investment losses may be larger for you than for other people. That means you may find it difficult to recover from losses in time to reach your long-term goals - even if emotionally, you feel prepared to take on that risk. Your advisor can help you identify investment strategies that may be a good fit for your current financial situation.
Based on your answers, you may feel some
impact from investment losses. If you need
to access your money soon or have several
financial obligations,
you may want to opt for lower-risk
investments. But if you're comfortable with
how much you have saved and feel financially
stable,
investing in higher-risk assets could
potentially grow your returns. Your advisor
can help you build a portfolio that works
for your needs.
Based on your answers, investment losses aren't likely to significantly impact your ability to reach your financial goals. You may have the capacity to invest in volatile investments with high return potential. However, it's always a good idea to regularly check in with your advisor to assess if your financial situation has changed.
Read our article on the "bucket" portfolio
approach
Read our article on two ways to
drive your investments
Read our article on the value of
working with a financial advisor
Read our article on the benefits of
investing regularly
Read our article on how taxes and
inflation could impact your returns
Read our article on how to get
back on track in uncertain times
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Risk tolerance
- Your willingness to take risk
- Reflects your personality, your beliefs and your investment experience
Risk capacity
- Your ability to absorb the impact of investment losses as you pursue higher potential returns
-
Varies with your age, income and financial goals
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Case study:
Risk tolerance
risk capacity
Hana and Haysam have identical incomes. Both are age 45. Both plan to retire in 20 years. But that’s where the similarities end. One of these two investors has a much higher risk capacity.
Hana lives alone, has no debt and no dependents. Thanks to a good job and a good company pension, she is on track to reach her savings goal for retirement. She has already paid off her mortgage and has an emergency fund. Her next savings goal is for travel. Even if she has a lower risk tolerance personally, Hana clearly has a high risk capacity. She has no immediate need to access funds from her investments. And, if she chooses investments with higher risk and higher growth potential, she could benefit financially from putting some of her risk capacity to work.
Haysam is a risk-taker by nature. He spent his emergency savings to start his own business. He is the primary income earner in a family of five. Two of his three children will be heading off to university over the next three years. Haysam has paid down half of his mortgage and has some retirement savings, but he has no pension. With more financial obligations and less money saved, his capacity for risk is lower – despite his higher personal tolerance for risk.
Look for the right balance
Ideally the investments you choose are in line with your risk tolerance and your risk capacity. If not, you may take on more risk than you can afford – or sit in safety to such a degree that your savings grow too slowly. Either way, you may find it more challenging to reach your financial goals. That’s why it’s important to understand your own unique approach to risk and how it affects you. Investors often find that working with an advisor helps them achieve an objective and accurate understanding of their financial position. This is essential to making a well-informed decision that considers both risk tolerance and risk capacity.
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