What is risk tolerance in investing? The amount of risk you can or are willing to take in relation to potential returns. Diversification is one way to cut risk, but we have a lot more tips for you

What is risk tolerance in investing? It’s fair to say that “high risk” investments carry a substantial chance of big losses, as in penny stocks, options and so on. A government bond would be “low” risk. Well-established, profitable and dividend-paying stocks would be “medium” risk.

Meanwhile, investors can help minimize the risk of portfolio imbalance by diversifying. This has two benefits. It keeps you from investing too heavily in any industry or sector that is headed into a period of big losses. In addition, by spreading your investments out more widely, you improve your chances of latching onto a market superstar—a stock that will wind up producing two or five or 10 times more profit than average. Over the course of any investing career, you need a few super stocks in your portfolio to offset the losses you’ll have from the inevitable duds.

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What is risk tolerance in investing? Apply our 5% to 10% rule so you can avoid excessive risk

Every case is different, because each individual has different investment objectives, acceptable risk levels and so on. But you should generally hold on to high-quality stocks, even if they have jumped in price. As well, typically, we advise that a stock shouldn’t make up more than, say, 5% of a portfolio. (However, it could make up as much as 10% if the value rises and it’s not a risky or speculative stock.) So, you could also take partial profits in stocks that make up a disproportionately high part of your portfolio.

You also need to consider your diversification across the five main economic sectors. For example, if your exposure to the more volatile Resources sector is too high, then you may want to sell some of your Resource holdings to cut risk.

Diversify between investment approaches and across geographic areas to minimize your risk

One of the worst things you can do is invest so that your portfolio would suffer greatly due to a localized downturn in any one city, state or province. Ideally, your portfolio should give you exposure to much of the North American economy, plus substantial international exposure, if only through North American multinationals.

Balance aggressive and conservative stocks in your Successful Investor portfolio in line with your investment objectives and risk tolerance. Above all, avoid the urge to become more aggressive as prices rise and more conservative as prices fall.

We believe you should develop a clear idea of how much risk you are willing to accept, through good times and bad. For example, some investors become more aggressive as the market rises and more conservative as the market falls. The problem here is that all market trends, up or down, eventually reach a turning point. If you take on more risk as the market rises, you’ll wind up owning your riskiest portfolio just when the market is near a peak. That’s when risky stocks can do their greatest harm to your net worth.

Furthermore, building a balanced Successful Investor portfolio should include a mix of growth and value stocks, big and small stocks, and so on.

What is risk tolerance in investing? Invest in speculative stocks and you may get high returns, but you also take on considerable risk

Speculative investments are higher-risk stocks with uncertain prospects. They are far riskier than what we call aggressive stocks—stocks with sound prospects, but that have added risk in their industry or particular situation. They also typically don’t have the secure hold on the growing or at least stable clientele that conservative stocks have.

Speculative stocks can offer significant returns to investors—but they will also have risk to match. High-risk, high-reward investors are typically drawn to speculative stocks.

Use our three-part Successful Investor approach to cut your overall portfolio risk

Some investors feel it’s “safer” to include substantial holdings of cash and bonds in a portfolio, rather than focus on stocks. It’s true that this can potentially dampen a portfolio’s volatility, since the value of the cash won’t change, and the values of the bonds and stocks may often move in opposite directions.

However, we think it’s far better to invest in stocks using our three-part portfolio management philosophy.

1. Hold high-quality, mostly dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

How has your risk tolerance changed throughout your investing career?

What is the riskiest stock you’ve ever owned, and how did it perform for you?