Some people love roller coasters. They scream and laugh through the drops and twists, and before the ride even stops, they’re ready to go again. Others hate the whole experience. If they get on the ride at all, they close their eyes, grit their teeth, and white-knuckle it to the end.
Investing is a lot like riding a roller coaster. Some love the thrill of taking big risks with the possibility of getting even bigger rewards. Others get anxious with every market dip and downturn.
Metaphors aside, your attitude toward risk when it comes to things like roller coasters, parachuting, and bungee-jumping doesn’t necessarily indicate how you’ll deal with financial market volatility.
Knowing yourself and your risk tolerance is an essential part of investing. Of course, it’s good to have a diversified portfolio that is built for your goals in mind, but 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—selling at a loss or altogether abandoning your plan to save—that could potentially cost you even more.
What is Risk Tolerance?
Risk tolerance is the amount of risk an investor is willing to take—and that tolerance level is made up of three different factors: risk capacity, need, and emotional risk.
This is the ability to handle risk financially. How much can you afford to lose without it affecting your security? 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.
For example, If you’re young and have plenty of time to recover from say, a big market loss, you may decide it’s okay to be a little aggressive with your asset allocation. In that case, your capacity might be larger than if you were older and close to collecting your last paycheck. In that instance, 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.
Another example of lower risk capacity: If you have serious financial obligations (a mortgage, your own business, a wedding to pay for, or kids who will have college tuition), you may not be in a position to comfortably ride out a bear market with risky investments. In that case, you may choose to go with safer investments in order to better protect your portfolio.
On the other hand, if you have other 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.
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 what is an appropriate amount of risk to meet your goals. For example, if you have $100 million and expect that to comfortably support your goals, 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 right answer. Following the example above, it may in fact 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 certain investment?
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 a little crazy. They may lose sleep or be tempted to sell low and put all their remaining money in a nice, safe savings account or CD.
On the flip side, when the market is great, an investor may get a case of the greedies and decide to buy high or move their safe investments to something much more aggressive. Whether it’s FOMO, 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.
Types of Risk Tolerance
Generally, investors fall into one of these three categories when it comes to investment risk tolerance.
1. Aggressive risk tolerance: People with aggressive risk tolerance tend to keep their 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, then you will likely see periods of significant investment success that is, at some point, followed by big losses. In other words, you’re likely to ride the full rollercoaster of market volatility.
2. Moderate risk tolerance: This person balances potential risk with potential reward, wanting to reduce the former as much as possible while enhancing the latter. This investor is often comfortable with short-term losses of principal if the long-term results are good.
3. Conservative risk tolerance: Although this person is usually willing to accept a relatively small amount of risk, he or she truly focuses on preserving principal. Overall, the goal is minimizing risk and principal loss, with the person agreeable to receiving lower returns in exchange.
While the financial industry tends to use labels like conservative, moderate, or aggressive to describe risk in the context of investments and investors, those terms are subjective. What they mean to you may be different from what they mean to someone else.
It can put things into better perspective to think of a potential loss in terms of dollars and not percentages. A 15% loss might not sound so bad, but if you think of it as having $10,000 one month and $8,500 the next, that’s a little more daunting.
Each investor may have their own unique level of risk tolerance, thought generally the levels are broken down to 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 obtain a good understanding of the degree of risk tolerance required to help meet those goals.
Investors may choose to diversify and divide their investments into buckets—with some safer assets, some intermediate-term assets, and some for long-term growth—all based on their personal goals and timeline.
Ready to take steps toward your financial future? With SoFi Invest®, investors can set up an investment account that takes their goals, risk tolerance, and other personal factors into consideration. SoFi’s automated investing platform invests in exchange traded funds (ETFs), which offer an easy, low-cost way to get into a diversified portfolio, via its automated investing platform.
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