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.
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.
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Otherwise, you might resort to knee-jerk decisions—selling at a loss or abandoning your plan to save—that could cost you even more.
What is Risk Tolerance?
Risk tolerance is the amount of risk an investor is willing to take to achieve their financial goals. Risk tolerance level comprises three different factors: risk capacity, need, and emotional risk.
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Risk capacity is the ability to handle risk financially. 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 loss, 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 safer investments, like bonds or dividend stocks, to better protect 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.
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.
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 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 safe 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.
Types of Risk Tolerance
Generally, investors fall into one of three categories regarding investment risk tolerance: aggressive, moderate, and conservative.
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 differ from what they mean to someone else.
It can put things into better perspective to think of a potential loss in terms of dollars, 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.
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.
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.
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.
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 safer assets, some intermediate-term assets, and some for long-term growth — based on their personal goals and timelines.
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