What is your risk (or volatility) tolerance?

I am risk averse; I do not want to lose money. I define risk is the probability of permanent capital loss. Most in the financial industry, however, risk is defined as the volatility of the market or the beta of a stock, meaning how far does the value of your investments deviate from the long-term or market return. Volatility is non-directional and refers to both the up and down cycles of volatility, which average out over time. Volatility may cause you to realize capital loss if you sell your investment (e.g. during retirement) at the lows, but volatility can also give you higher gains. I do not worry about higher gains, I only worry about losing money.

Usually, financial advisers will classify your risk tolerance as being "conservative," "moderate," "balanced," "growth," or "aggressive." They then say how much assets should you allocate to domestic stocks markets, international stocks, and bonds. I think these classifications are meaningless and associated asset allocation arbitrary. Everyone should be risk averse; no one should gamble their money.

I believe risk tolerance, or (more accurately) volatility tolerance, is a function of how much volatility in the value of your investments can you tolerate over time without losing money. If you have plenty of time before retirement, a stable income, a few years worth of emergency cash reserve, sufficient insurance coverage, no financial dependents, and not expecting any life changes, you can tolerate high volatility over a long time without realizing capital loss. The most important issues affecting your risk tolerance is the time you have and your financial stability. As long as you have sufficient time and financial stability, you should put all your other assets in stocks and equity investments.

Here's a list of issues affecting your risk/volatility tolerance:

Time: How many years do you have until you need you need to sell your investments (e.g. retirement)? If you are one year away from retirement, negative volatility may force you to sell at a loss. If you have 30 years to invest, volatility should not matter because the positive and negative cycles tend to average out over time.

Income stability: How stable is your income? If you have a stable job and can easily find another job without retraining, volatility of your investments should not affect your finances now. If your job and skills are on the edge of obsolesce, you may be forced to liquidate your investments to survive while you retrain and look for another job.

Emergency cash reserve: How many months of living expense do you have in your emergency cash reserve? If you have plenty of emergency cash reserve, you can live through financial emergencies without tapping into your investments. If you do not have sufficient emergency cash reserve, financial emergencies may force you to sell your investments at a loss.

Insurance: Do you have sufficient medical, disability, and, if necessary, life insurance coverage? This will affect whether you can afford to go through a medical emergency without tapping into your investments and realizing capital loss.

Financial dependents: How many financial dependents do you have? This will affect whether your job stability/availability, emergency cash reserve, and insurance are enough for you to be considered financially stable.

Life changes: What life changes are you expecting? Are you anticipating getting married, having children, needing medical attention, or poorer job prospects? This also affects how you determine whether you are financially stable.

Intrinsic value of investment: What is the intrinsic value of your investment and the risk of capital loss? If you know the market price of your investment is far below its intrinsic value and the risk of permanent capital loss is limited, as long as you don't need to liquidate your investment before the realization of intrinsic value, volatility should not matter.

***

How comfortable are you with volatility? Some argue you need to take into consideration emotional tolerance to volatility. As long as you are financially stable, I would argue that emotional tolerance can be handled by education, by putting a trusted financial adviser between you and your investments to handle your emotions, or by deliberately ignoring your investments. However you handle your emotions, be risk averse and don't lose money.

Clarification: I am writing with my personal bias to value investing in equities. For most investors, they are probably better off investing in broad market index funds and spreading their investment in all asset classes, including stocks, bonds, real estate, commodities, and cash, to achieve low correlation.

Related posts:

• Build an emergency cash reserve.
• Minimize capital loss.
  
• The principles of value investing.
  
• The principles of wealth accumulation.
  

References:

• Wikipedia:
• Financial risk.
• Volatility.
  
• Beta coefficient.
• The Benefits of Low Correlation (by Craig Israelsen).
  

P.S. This post was featured in the Carnival of Personal Finance #152 at Money Under Thirty.