Tolerance rates: What kind of a risk taker are you?

FRIDAY, OCTOBER 14: Having a good understanding of your risk tolerance is crucial to making a successful investment decision and forming a relationship with your wealth manager.

As wealth managers, we usually determine a person’s risk tolerance based on age, size of investment portfolio, financial obligations, expected retirement date and their need for funds.

These aspects can tell the wealth manager a lot about the level of risk that an investor can assume.

The importance of understanding what drives an investor’s willingness to take on risk falls into four different personality traits. 

Which one are you?

The low risk taker

Cautious investors make decisions based primarily on feelings and they are very sensitive to investment losses.

Fear drives their investment decision-making process.

They have trouble making proactive decisions regarding their investments and lack trust in investment advisors, rarely take the advice of others.

The portfolios of low risk investors usually consist of safe investments with the majority pacing below the rate of inflation and having a low turnover.

 The methodical risk taker

Methodical investors follow a disciplined, mechanical investing strategy. They make investment decisions based on hard facts and have the tendency to complain about small details.

They rely heavily on investment research and are not emotional about their investment decisions.

The higher risk taker

Spontaneous investors make investment decisions based on feelings and make them frequently.

These investors tend to always second-guess themselves and the advice of others and often chase the next big investment fad.

Their investment portfolios usually exhibit high investment turnover and may include riskier investments.

The individualist risk taker

Individualist investors make decisions based on hard facts and do not second guess their investments.

These investors exercise independent thinking and put a great deal of trust in their investment research.

They also feel extremely comfortable working with wealth managers.

So once you determine your risk personality type, you need to completely understand the term “risk and reward” or more importantly “risk versus reward,” and it’s not that simple.

If you knew that you would be rewarded for taking on a risk, you’re likely to accept that risk. 

However, it is important to remember that the greater the reward the greater the risk. 

At the low risk end is a Certificate of Deposit (CD)or term deposit, which is conservative and normally provides guaranteed investment income.

If you place $10,000 in a CD, you are guaranteed that you will get your principle of $10,000 back plus the guaranteed income at the rate you chose to invest the money, which currently is about 0.4 per cent at the local banks. You would earn $40 in a year.

What if you use $100,000 and buy a $100,000 piece of property instead?

At the medium risk level, there are no guarantees; the value of real estate is dictated by what the next person is willing to pay for it.

You may never see the $100,000 price again but you still hold the tangible asset that is the land.

But you stand to gain more if, for example, you clear the land and expose a view of the ocean.

You will then be in a position to sell it for $150,000 by simply adding value through water views.

Lastly, at the high-risk end, you decide to invest in gold as you have heard that it’s the next big thing.

You also hear that the price may increase to as high as $5,000 per ounce so you decide to buy gold stock instead of a coin or bar.

You expect returns of 20-30 per cent and you’re willing to take this riskier investment for the potentially higher return. 

However gold prices drop and your gold stock tumbles as well, turning your expected gain of 20 percent into a 20 per cent loss instead.

Understanding your risk tolerance is almost as important as understanding the investment itself. 

You may feel you have a high-risk tolerance but as it coincides with a rising market, you may soon discover that you have a low risk tolerance when the market softens. n

Carla Seely is a senior wealth manager at AFL Investments. She may be reached at 294-5712 or [email protected].