Definition and Example of Risk Tolerance
All investments carry some degree of risk. The amount of market risk you can stand is your risk tolerance. In simple terms, it is how much you are willing to be unsure about (and how much money you’re willing to lose), in the face of possible gains. For example, if you’re unwilling to lose much, or any, of your capital, you’d have a very low tolerance for risk. If you don’t mind risking some of your money for the chance to make big gains, your risk tolerance would be higher. Your risk tolerance depends on many factors, both personal and financial. Once you know how much risk you can tolerate, you can invest in line with your values and comfort level, and build a portfolio that matches your risk profile.
How Risk Tolerance Works
You can gauge your own level of risk with an online calculator or by talking to a financial planner. Financial planners use a person’s risk tolerance to tailor the financial advice they give. They can also use risk tolerance to identify their clients’ investing styles as aggressive, moderate, or conservative. Firms use these three categories as a shorthand way to describe asset options, suggest asset allocations, or offer strategies to their clients. Risk tolerance also involves a feature known as “risk capacity,” which identifies the amount of risk you can afford to take. It differs from the risk you are willing to take. For example, you may be fine with an aggressive, high-risk portfolio, but if you have only a few years to reach your goal, it does not suit your best interest to have a portfolio of 100% stocks—they’re too volatile. Suppose you have just started a new career and are planning to retire in 40 years. Your income is on the low side, and you have nothing in savings, but your cost of living is low, and you’re young, so those things will come in time. Suppose also that it’s in your nature to play big, roll the dice, and take leaps when given the chance. (In other words, you are risky by nature.) Your risk tolerance is high. Given all of these details, it makes sense that you’d go for a more aggressive approach, but your income and savings are low, so you might not be able to weather a severe price drop in your stocks. While you may have a high tolerance for risk, your capacity for risk is lower. In that case, you might be better served with a more conservative portfolio than you desire, to preserve the assets you’ll need to retire.
Assessing Risk Tolerance
If you have a financial planner, they might have tools such as risk tolerance tests, which come in a wide range of styles. Some ask yes/no questions, while others are more detailed questionnaires that ask you to predict how you might behave in the market. They may also ask how you approach risk in other parts of your life. You may be asked to rate your reaction to a given scenario on a sliding scale. You’ll also answer complex questions that make you think about the way you handle money and risk in all parts of your life. A question might ask how you would respond if the stock market were to fall by 20%. What would you do? An aggressive investor would most likely do nothing. A moderate investor might wait a few months to decide. A conservative investor might sell their stocks right away to stop future losses.
Types of Risk Tolerance
On a scale from least to most risky, the three levels of risk tolerance are:
Conservative: If you have a conservative risk tolerance, you would prefer to feel safe in how you choose to invest. You would rather avoid the risk of loss than take a chance on major gains. People with this risk profile tend to be older and less wealthy than others.Moderate: You can take on some risk, but within bounds. You may be willing to lose a portion of your money for the chance to make big gains but not not risk more than you can afford to lose.Aggressive: You can take big risks. You can handle major ups and downs in values and prices. You could have huge wins, and could also suffer major losses.
You may fall neatly into one of these categories, or you may straddle two. You may even find that you move among all three as you enter new stages in your life. Commonly, those who have an aggressive risk tolerance focus more on volatile assets, such as stocks, while conservative investors focus on more stable assets, such as fixed income. Typically, the younger you are, the more risk you can take on, because you’ll have more time to come back from downturns in the market. Investors with at least 10 years until they are due to retire often focus on growing their investments, while those who plan to retire in a few years often focus on preserving capital. The former depicts a more aggressive risk tolerance, while the latter is more conservative.
What It Means for Individual Investors
Every investor needs to gauge their risk tolerance before choosing investments. With that knowledge, you’ll have a better idea of which investment types work for your comfort level and which you should avoid. Otherwise, it’s hard to build a portfolio that fits your profile and meets your goals. Although risk tolerance is a vital part of any financial plan, many people do not account for it as much as they should. If you misjudge your risk tolerance or go against what you know to be true about yourself, problems can arise. Many investors make the mistake of thinking they have a high tolerance for risk, but they really don’t. Then, when the stock portion of their portfolio takes a drastic fall iin value, they panic and sell the stocks instead of riding out the market wave. They simple can’t stomach the thought of their investments sinking further. Their appetite for risk is lower than they thought. Being aware of your risk tolerance, and building a portfolio with that profile in mind, can prevent you from abandoning your financial goals by selling or acting on impulse due to market volatility.
