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Should my risk tolerance affect the types of investments that I pick for my RRSP?

Absolutely. All of your investing should take that into account.

Your risk tolerance is a measure of how comfortable you would be with the volatility your investments.

Generally, an investment with a higher risk also offers greater potential returns. For example, stocks have historically produced the biggest gains over the long term. If you couldn't sleep at night with that higher risk, however, it wouldn't be an appropriate investment for you. Government bonds or GICs might suit you better.

The risk of losing money on stocks can be reduced if you invest for the long term. That's why they make sense if you are investing for a retirement which is 10 or more years away. Your risk with investing in stocks is greatest if you need the money in just a year or two because the stock's price could be down at the time you need to receive your money back.

Stocks and bonds can be held by you directly or you can buy them indirectly by investing in a mutual fund that holds stocks or bonds.

We have talked about risk just in terms of the possibility of losing some of your principal or part of the original sum you invested. There's another, threat to your money. That is the risk of losing purchasing power through inflation.

Purchasing power, for a long-term investor, is what really counts. To maintain and add to the value of your assets, you need something that beats inflation. Stocks have traditionally done a better job of that than either bonds or cash. That's why equities are generally part of a balanced investment portfolio.

Aside from the "sleep factor", there are other questions to consider when determining your risk tolerance. These include:

  • Have you ever owned stocks before?
  • How many years away is your retirement?
  • What would you do if the stock or mutual fund you bought last year lost 10 or 20%?

Some financial planners use the "100 minus your age" formula to get a rough idea of what your appropriate mix of assets should be.

To calculate it, subtract your age from 100: the answer gives you an idea of what percentage of equities you should hold in your portfolio.

Example:

A 60-year-old's portfolio, following this rule, would have 40% equities. If this person's risk tolerance is high, the ideal mix might be boosted to 50% equities, with 35% fixed income and 15% cash. If, instead, the person's risk tolerance is low, the equity component may be dropped to 30%, with 60% in fixed-income and 10% in cash.

More recently, some advisors have suggested hanging onto stocks or other equities for a longer period of time. Their argument? People are living in retirement longer than previous generations. Without some growth in their portfolio, there's a risk they will outlive their money.

Deciding on suitable investments depends on your own unique circumstances -- including your risk tolerance. Consider seeking professional advice.