What Is Risk Tolerance and How to Determine Yours
Risk tolerance refers to the level of risk an investor is willing or able to assume as a part of their investment strategy. Knowing yourself and your risk tolerance is an essential part of investing. Of course, it’s good to have a diversified portfolio built with your financial goals in mind.
Still, the products and strategies you use should ideally fall within guidelines that make you feel comfortable — emotionally and financially — when things get rough. Otherwise, you might resort to knee-jerk decisions, such as selling at a loss or abandoning your plan to save, which could cost you even more.
Key Points
• Risk tolerance is the level of risk an investor is willing to assume to achieve financial goals.
• Factors that influence risk tolerance may include risk capacity, need, and emotional risk.
• Investors tend to fall within or between three main categories of risk tolerance: conservative, moderate, and aggressive.
• Someone with a conservative risk tolerance may focus on preserving capital, as opposed to maximizing potential returns.
• Diversifying investments into different risk buckets can align your risk tolerance with your personal goals and timelines.
What Is Risk Tolerance?
As noted, risk tolerance is the amount of risk an investor is willing to take to achieve their financial goals when investing — whether through online investing or any other type of investing. In a broad sense, an investor’s risk tolerance level comprises three different factors: risk capacity, need, and emotional risk.
Risk Capacity
Risk capacity is the ability to handle financial risk. While it’s similar to risk tolerance, and can certainly influence it, it’s not the same thing. Unlike your emotional attitude about risk, which might not change as long as you live, your risk capacity can vary based on your age, your personal financial goals, and your timeline for reaching those goals. To determine your risk capacity, you need to determine how much you can afford to lose without affecting your financial security.
For example, if you’re young and have plenty of time to recover from a significant market downturn, you may decide to be aggressive with your asset allocation; you may invest in riskier assets like stocks with high volatility or cryptocurrency. Your risk capacity might be larger than if you were older and close to retirement.
For an older investor nearing retirement, you might be more inclined to protect the assets that soon will become part of your retirement income. You would have a lower risk capacity.
Additionally, a person with a low risk capacity may have serious financial obligations (a mortgage, your own business, a wedding to pay for, or kids who will have college tuition). In that case, you may not be in a position to ride out a bear market with risky investments. As such, you may use less-risky investments, like bonds or dividend stocks, to balance your portfolio.
On the other hand, if you have additional assets (such as a home or inheritance) or another source of income (such as rental properties or a pension), you might be able to take on more risk because you have something else to fall back on.
Recommended: Savings Goals by Age: Smart Financial Targets by Age Group
Need
The next thing to look at is your need. When determining risk tolerance, it’s important to understand your financial and lifestyle goals and how much your investments will need to earn to get you where you want to be.
The balance in any investment strategy includes deciding an appropriate amount of risk to meet your goals. For example, if you have $100 million and expect that to support your goals comfortably, you may not feel the need to take huge risks. When looking at particular investments, it can be helpful to calculate the risk-reward ratio.
But there is rarely one correct answer. Following the example above, it may seem like a good idea to take risks with your $100 million because of opportunity costs — what might you lose out on by not choosing a particular investment.
Emotional Risk
Your feelings about the ups and downs of the market are probably the most important factor to look at in risk tolerance. This isn’t about what you can afford financially — it’s about your disposition and how you make choices between certainty and chance when it comes to your money.
Conventional wisdom may suggest “buy low, sell high,” but emotions aren’t necessarily rational. For some investors, the first time their investments take a hit, fear might make them act impulsively. They may lose sleep or be tempted to sell low and put all their remaining cash in a savings account or certificate of deposit (CD).
On the flip side, when the market is doing well, investors may get greedy and decide to buy high or move their less-risky investments to something much more aggressive. Whether it’s FOMO trading, fear, greed, or something else, emotions can cause any investor to make serious mistakes that can blow up their plan and forestall or destroy their objectives. A volatile market is a risk for investors, but so is abandoning a plan that aligns with your goals.
And here’s the hard part: it’s difficult to know how you’ll feel about a change in the market — especially a loss — until it happens.
The Levels of Risk Tolerance
Generally, it’s possible to silo investors’ risk tolerances into a few key categories: aggressive, moderate, and conservative. But those terms are subjective, and depending on the institution they can be broadened to include other levels of risk tolerance (for example, a moderate-aggressive level). But because risk tolerance is subjective, the percentages of different assets is hypothetical, and ultimately an investor’s portfolio allocation would be determined by the individual investor themselves.
Again: the hypothetical allocation or investment mix, as it relates to any individual investor’s risk tolerance or risk profile, is not set in stone. You can read more about conservative, moderate, and aggressive risk tolerances below, but first, to help you get an idea of what the investment mix or allocation might look like for a broader range of risk tolerance profiles, here’s a hypothetical rundown of how an investor from each category might allocate their portfolio:
|
Risk Tolerance Level and Hypothetical Investment Mix |
||
|---|---|---|
| Bonds, Cash, Cash Equivalents | Stocks | |
| Conservative | 70% | 30% |
| Moderately Conservative | 55% | 45% |
| Moderate | 40% | 60% |
| Moderately Aggressive | 27% | 73% |
| Aggressive | 13% | 87% |
And, as promised, here’s a bit more about what the three main risk tolerance categories could entail for investors:
Conservative Risk Tolerance
A person with conservative risk tolerance is usually willing to accept a relatively small amount of risk, but they truly focus on preserving capital. Overall, the goal is to minimize risk and principal loss, with the person agreeable to receiving lower returns in exchange.
Moderate Risk Tolerance
An investor with a moderate risk tolerance balances the potential risk of investments with potential reward, wanting to reduce the former as much as possible while enhancing the latter. This investor is often comfortable with short-term principal losses if the long-term results are promising.
Aggressive Risk Tolerance
People with aggressive risk tolerance tend to focus on maximizing returns, believing that getting the largest long-term return is more important than limiting short-term market fluctuations. If you follow this philosophy, you will likely see periods of significant investment success that are, at some point, followed by substantial losses. In other words, you’re likely to ride the full rollercoaster of market volatility.
How to Determine Your Own Risk Tolerance
Risk Tolerance Quiz
Take this 9 question quiz to see what your risk tolerance is.
⏲️ Takes 1 minute 30 seconds
There are steps you can take and questions to ask yourself to determine your risk tolerance for investing. Once you know your risk preference, you should be able to open a retirement account with more confidence. Both low risk tolerance and high risk tolerance investors may want to walk through these steps to ensure they know what investment style is right. Matching your specific risk tolerance to your personality traits can help you stick to your strategy over the long haul.
Consider the following questions, especially as they relate to your post-retirement life – or, what your life might look like once you reach your financial goals (which, for many people, is retirement!).
1. What will your income be? If you expect your salary to ratchet higher over the coming years, then you may want to have a higher investment risk level, as time in the market can help you recover from any losses. If you are in your peak-earning years and will retire soon, then toning down your risk could be a prudent move, since you don’t want to risk your savings this close to retirement.
2. What will your expenses look like? If you anticipate higher expenses in retirement, that might warrant a lower risk level since a sharp drop in your assets could result in financial hardship. If your expenses will likely be low (and your savings rate is high), then perhaps you can afford to take on more retirement investing risk.
3. Do you get nervous about the stock market? Those who cannot rest easy when stocks are volatile are likely in a lower-risk, likely lower-return group. But if you don’t pay much attention to the swings of the market, you might be just fine owning higher-risk, (potentially) higher-return stocks.
4. When do you want to retire? Your time horizon is a major retirement investing factor. The more time you have to be in the market, the more you should consider owning an aggressive portfolio. Those in retirement and who draw income from a portfolio are likely in the low risk-tolerance bucket, since their time horizon is shorter.
The Takeaway
Risk tolerance refers to an investor’s comfort with varying levels of investment risk. Each investor may have a unique level of risk tolerance, though generally, the levels are broken down into conservative, moderate, and aggressive. The fact is, all investments come with some degree of risk — some greater than others. No matter your risk tolerance, it can be helpful to be clear about your investment goals and understand the degree of risk tolerance required to help meet those goals.
Investors may diversify their investments into buckets — some less-risky assets, some intermediate-term assets, and some for long-term growth — based on their personal goals and timelines.
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