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- Published: June 20, 2023
- Updated: July 10, 2023
- 6 min read time
- This page features 1 Cited Research Article
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Risk tolerance is your willingness to lose some or all of your original investment in exchange for a potentially greater return in the future. In other words, it’s an investor’s comfort level during an unpredictable or volatile market.
A few factors influence an investor’s risk tolerance, such as their age, income and financial goals. There is no right or wrong risk tolerance — comfort levels are unique to each individual.
When investing, knowing how much risk you’re comfortable with is very important. Let’s explore the relationship between tolerance and risk and how you can assess which level you fall under.
Why Risk Tolerance Matters
Your risk tolerance plays a crucial role in strategizing your ideal asset allocation, allowing you to meet your financial goals without losing sleep from your choices. Many financial advisors and planners will use their client’s risk tolerance to tailor a financial plan specific to their needs and goals.
That said, “risk” can mean different things to different people. For example, one individual might interpret risk as losing everything, while another might view loss as part of the process. Whichever way you define it, finding a balance between risk and return can set up the right asset allocation and help you become a successful investor.
Risk Tolerance Levels
During a volatile market, will you sell or stay the course? Can you sleep soundly without worrying about your investments? How you respond in these situations and scenarios can give insight into your level of risk tolerance.
Check out the risk scale below for an idea of which level you may fall under.
Some investors don’t not want to risk losing their money or need to live off their investments. They don’t like volatility and would rather avoid high-risk investments. Most conservative investors are in their later stages of life, such as nearing retirement. They’re not too concerned about becoming wealthy but rather funding their lifestyle.
With a conservative investing style, an example portfolio may consist of 40% bonds and 60% stocks or vice versa.
Moderate investors are willing to wait longer to reach their financial goals. They typically start investing at key points in their life, such as during their first stable job, marriage or after having children.
Many retirees fall within the moderately-conservative range, where they’ll want some exposure to higher-risk investments because they either haven’t saved enough money for retirement or have suffered losses over the years.
With a moderate investing style, your ideal portfolio may consist of 20% bonds and 80% stocks, or a 30% bonds and 70% stocks ratio.
Investors looking to match or beat market returns have a more aggressive investing approach. They’re most likely looking to save for retirement at an accelerated pace and are willing to take on the added risk.
Aggressive investors are typically in their 20s and 30s, so they haven’t suffered a significant loss of funds. At this stage in life, a longer time horizon can work in your favor against risk. This is because young investors have room to recover from losses long before retirement.
For example, someone aged 26 and at the height of their career would probably be more willing to lose his capital in exchange for potentially higher returns than a person aged 62 planning to retire soon. Someone closer to retirement would most likely prefer more predictable returns for minimal losses.
With an aggressive investing style, an example portfolio may have a ratio of 10% bonds and 90% stocks.
How To Assess Your Risk Tolerance
Now that you’re familiar with the different investing styles, it’s time to consider your risk tolerance. Here are five key factors to consider when determining your risk tolerance.
What is your personal financial situation? For example, if you have a stable job with a consistent income, you may be okay with taking greater risks in your portfolio. However, if your income is inconsistent, such as a contract position or a self-owned business, taking a more moderate or conservative stance on your portfolio may make more sense.
2. Time Frame
Are you looking to retire soon or further down the line? Safe stocks—those with relatively stable returns over time, are generally a preference for investors nearing retirement.
3. Personal Obligation
Are you single with no dependents? If so, you can have more flexibility and freedom to take on greater risks. On the other hand, if you have a large family with people dependent on you financially, you may prefer more stable returns.
4. Financial Goals
When planning to build substantial wealth, you must be comfortable with risk. In this scenario, taking on greater risk could mean earning higher returns more quickly or losing a greater portion of your capital. However, if your goal is comfort, you’re probably fine with taking less risk.
5. Personal Tolerance Level
Think about your general tolerance level outside of money and investing. How do you approach risk in other aspects of your life? For example, are you strategic in planning out a vacation or up for more spontaneous adventures? Consider the level of the worst-case scenario you are comfortable with, and be realistic about how you’ll react.
A financial planner can guide you through these types of questionnaires to determine your level of risk tolerance, such as the one below:
Frequently Asked Questions
1 Cited Research Article
- Underwood, K. (2022, July 19) Risk Tolerance and risk capacity go hand-in-hand when creating an investment strategy. Retrieved from: https://www.businessinsider.com/personal-finance/risk-tolerance-vs-risk-capacity