Risk tolerance is your ability and willingness to accept (read: stomach or sleep at night during) a decline in the value of your investment.
Before investing in anything, including commercial real estate it is critical to understand your risk tolerance.
All investing carries a level of risk and that means potential for loss of capital, it also means potential for capital growth.
When you’re trying to determine your risk tolerance, ask yourself how comfortable you will feel when the commercial real estate market is experiencing value declines and your asset value is also decreasing in value, perhaps as a result of increasing interest rates, decreasing rents, reduced demand, increased supply, loss of business confidence in the economy etc.
These five questions can help you assess your risk tolerance.
What are your investment goals?
What's your investment time horizon?
How comfortable are you with short-term loss?
Do you have non-invested savings?
Do you plan on tracking your investment on a day-to-day, week-to-week, or only semi-regularly?
1. What are your investment goals?
Start by asking yourself why you’re investing. While people invest for a variety of reasons, the main reason is typically to increase our wealth in some way shape or form.
Some common goals include:
Retirement
Buying a house
Paying for your children’s education
Financial independence
Having a goal in mind can help you assess your timeframe and estimate how much money you’ll need.
Determining your "why" of investing is the first step toward understanding how much risk you’re willing to take on and why.
2. What's your time horizon?
Your investment goals will help you establish the time horizon for your investments. Your time horizon is when you plan on using the money you've generated from your investment.
Depending on your life stage but generally, the longer the time horizon, such as saving for retirement, the more risk you can take on. If your investments decrease in value, you have more time for the price to increase again. While downturns do occur, and past performance is no guarantee of future results, review the returns of different asset classes over the last 1, 3 and 20 years to see which asset class is a better vehicle to achieve your goals.
If your goal requires you to either get rich quick or earn a big return in a short time period, you’ll need to be very comfortable with risk. Remember that if the market falls suddenly in your timeframe, you may not meet your goal on time.
3. How comfortable are you with short-term loss?
Investment values can and will fluctuate in the short term. It’s important to remember that with stocks, residential and commercial real estate your investments may decline in value, but it's important to remember that you don’t realise the loss until you sell the investment.
If you need your money in the near-term, you may be forced to sell at a loss. Investors with a longer time frame can hold onto the investment in the hopes it will recover and potentially increase in value with time.
Given your goals and your time horizon, are you able to absorb a loss in the short term? Risk-averse investors may choose to invest in a diverse portfolio of stocks, bonds, residential and commercial real estate assets, so that a decline in one asset class has less impact on the broader investment portfolio.
4. Do you have non-invested savings?
Regardless of your risk tolerance, it’s important to have some savings set aside in liquid accounts. If you face an emergency, like a job loss or accident, you can easily access cash without having to liquidate any investment accounts.
However, if you’re keeping a large portion of your savings in cash because you’re nervous about investing, this is likely a sign you’re risk averse.
5. Do you plan on tracking your investments day-to-day, week-to-week, or only semi-regularly?
Suppose you invested in an ASX listed business, a residential or commercial property. Would you anxiously scan the business section of your paper or follow the ups and downs through an app on your phone, would you spend all your time on REA and PriceFinder to see what the algorithm thought?
If so, are you doing it because you’re nervous, or because you’re excited about new investing opportunities?
If every dollar decrease in value makes your stomach drop, a diversified portfolio and a focus on long-term goals will make these down periods more bearable. Keep in mind, diversification and asset allocation do not guarantee returns or protect against losses.
If you’re actively looking for investments and buying opportunities when you track the market, you might be willing to take on more risk purely due to the fact that you understand the market more. While a high tolerance for risk can pay off, reacting solely to media headlines can lead to unnecessary risk.
Conclusion
While every investment comes with risks, understanding the balance of risk and reward that works for you is the basis for building a diversified portfolio. Consider working with a financial professional to assess your risk tolerance and develop a plan that helps address your specific financial goals.