Feb 5, 2024
Risk Tolerance: What it Is and How To Determine Yours
Risk tolerance is the amount of uncertainty you’re willing to allow in your investment portfolio. Depending on your financial goals, age, time horizon, and a few other factors, you’ll likely fall into one of three risk tolerance categories: conservative, moderate, or aggressive.
It’s no secret that all investment comes with risk, so investors must be prepared to tolerate some level of uncertainty. Developing an investment strategy that accounts for your comfort with potential stock market volatility and aligns with your financial goals can help with prioritizing risk management when you’re building your portfolio. If you’re the kind of investor willing to risk losing money in the short term if you think long-term gains are possible, your investment strategy may be more aggressive. On the other hand, if you’re approaching retirement, more short-term risk could be outside your conservative comfort zone. Understanding your risk tolerance before entering the market reduces stress and guides you toward the investments that make the most sense for you.
Here’s what we’ll cover:
- What is risk tolerance?
- Risk tolerance factors
- Risk profiles
- Risk tolerance and investment strategies
What is risk tolerance?
Investment risk is the degree of uncertainty about an investment’s future returns. Risk tolerance is how much of that uncertainty you’re willing to take on. Your risk profile is an evaluative measure that helps you determine your risk tolerance by considering your goals, age, time horizon, current financial situation, and more. As an investor, you can’t eliminate risk entirely. However, you can gain an understanding of your risk tolerance level and learn to balance growth potential and loss aversion when investing. Further, understanding your risk tolerance can help you optimize potential investment profit while reducing panic-selling or other emotional reactions to market swings.
Factors that affect your risk tolerance
You can determine your risk tolerance by considering several factors about your current situation and future plans. No one element will determine your risk tolerance, but considering them all together can give you a well-rounded view. Keep in mind that as these things change over time, your risk tolerance may shift as well.
- Age: Younger investors are generally focused on long-term gains that can shape their financial future, so they’re more open to risk in the near term. Conversely, people nearing retirement are more likely to seek stability.
- Goals: Depending on what you’re working toward, you might optimize your portfolio for short-term returns, long-term gains, or another investment objective you hope to achieve. Whether you’re saving for retirement, buying a house, putting your children through college, or working to be financially independent, clear and realistic investment goals can guide your approach to risk management.
- Time horizon: What are you saving for, when do you plan to withdraw the money you’ve invested, and, if you’re investing for retirement, how long do you need that money to last? In general, if you’ve got a longer time horizon, you can afford to take more risks, because you have time to bounce back from short-term losses.
- Comfort with short-term losses: It can be unnerving when the value of your investments takes a hit, even when you’re following a buy-and-hold investment strategy. Are you willing to endure some short-term losses now in the name of potentially larger long-term gains later? Or do you prefer lower but steady, reliable returns with less risk of short-term loss?
- Comfort with investing: Understanding how various investment classes work, learning how to read a stock prospectus, navigating market volatility… it can all be extremely stressful for some investors, while others take it in stride. Your overall comfort level with any type of investing plays a part in your risk tolerance.
- Financial security: There’s a difference between how much risk you want to take on and how much risk you can actually handle financially. Your risk appetite, or the amount of risk your current financial situation actually allows for, helps determine your risk tolerance. Generally, investors with more savings and assets, i.e. more financial security, can take on more risk than those with tight budgets, large amounts of debt, or unstable financial circumstances.
As you get older and your lifestyle, income, and general financial situation change, you may notice your risk tolerance becoming more conservative. That’s not uncommon, since investors nearing retirement age often have less time to recover from market downturns. Younger investors may skew more moderate or aggressive given the potential for long-term gains.
Your risk profile can help you determine the right asset allocation for your investment portfolio. For example, more risk-averse investors tend to go for more bond investments, while high risk tolerance investors lean more heavily toward stocks. Evaluating your risk profile helps you determine whether your overall risk tolerance is conservative, moderate, or aggressive.
Conservative risk tolerance
Conservative investors are typically focused on protecting their assets and maintaining wealth. If you have a low risk tolerance, you’ll generally prefer stability and low volatility. That might mean smaller gains, and you’re okay with that. But you do want to see some growth potential, too. A typical conservative risk portfolio contains about 40% stocks and 60% bonds. Some low-risk investment options include CDs, money market funds, corporate bonds, and dividend-paying stocks.
Moderate risk tolerance
Moderate risk investors are looking to balance long-term growth potential and a reasonable amount of stability. This middle-of-the-road investment approach generally means that moderate investors see lower returns than their aggressive counterparts but avoid huge losses when the market falters. A typical moderate risk portfolio contains about 60% stocks and 40% bonds. Preferred investment vehicles include exchange-traded funds (ETFs), mutual funds, index funds, dividend-paying stocks, and corporate bonds.
Aggressive risk tolerance
Aggressive investors want to maximize returns in the long run, even if it means sacrificing stability in the near term. They’re often young people with long investment windows who are willing to take on high-risk, dynamically priced, high-yield investments because potential loss could be outstripped by potential gain later. A typical aggressive risk portfolio contains about 80% stocks and 20% bonds. Preferred investment vehicles include growth stocks, real estate, and high-yield bonds.
Your risk tolerance and your investment strategy
The amount of risk you’re comfortable with can be a guiding principle for your investment strategy. For example, if your risk tolerance is low, investing in higher-risk asset classes like equities and real estate may not be for you. Market volatility, or the frequency and magnitude of stock price swings either up or down, can be stressful for new or risk-averse investors who want to protect their assets. On the other hand, if you’re an aggressive investor hoping to maximize profits, a strategy focusing on mutual fund investment won’t likely get the results you want. Mapping out your investment strategy according to your risk tolerance ensures that you’re focusing on the assets that will help you reach your financial goals.
Risk tolerance and types of investments
Every investment option comes with a certain level of risk and potential volatility. Although it’s impossible to predict the market, historical data can reveal how particular assets have performed over time. That info can help you determine which types of investments may be better suited to your risk tolerance level.
- Stocks: Historically, stocks have produced the highest rate of return across asset classes. The trade-off is that stocks are also one of the most volatile investment options.
- Bonds: The bond issuer’s promise to repay the principal plus interest generally makes bonds less risky than stocks.
- ETFs: Because ETFs contain a basket of different assets, there’s some built-in diversification, so they’re considered lower risk than stocks but slightly riskier than bonds.
- Mutual funds: Like ETFs, mutual funds are seen as relatively less risky than stocks because they contain a mix of investments.
Risk tolerance and diversification
Regardless of your risk tolerance level, diversifying your portfolio is considered a wise risk management practice. Diversification involves holding a variety of asset classes, as well as investing in a range of industries and sectors, so that losses in one type of investment are balanced by gains in others. Maintaining a diversified investment portfolio can help reduce overall risk and strike the right balance between risk and reward no matter what the market brings.
Know your risk tolerance, grow your money
Financial planning may seem intimidating at first, but once you understand your risk tolerance you’ll feel more empowered to make the investment decisions that work for you. There are many options for growing your money, and risk levels vary from low to high even among high-yield investment vehicles.
If you’re nervous about investing, you’re not alone. Even people with conservative risk profiles can open a brokerage account and put together a portfolio of low-risk investments to get started with more confidence.
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