Table of Contents
What is risk tolerance?
3 general categories of risk tolerance
5 factors that influence risk tolerance
Risk tolerance vs. risk capacity
Why understanding risk tolerance is important
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What Is Risk Tolerance & Why Is It Important?
Jun 21, 2022
6 min read
Risk tolerance is a term that describes an investor’s willingness to consider that an investment could come at a loss.
A fundamental truth about investing is that risk and reward are linked. All investments involve risk to varying degrees, and securities like stocks, bonds, mutual funds, and others come with the possibility of money loss. Volatility in the stock market, domestic and world economic events, interest rate changes, and other factors can affect investors’ portfolios.
Risk tolerance is a term that describes an investor’s willingness to consider that an investment could come at a loss. An investor’s age, investment goals (say, vacationing throughout retirement), income, and even the way they were raised to view risk can determine their threshold.
Beyond those risk tolerance factors, an investor’s ability to stomach potential losses is, at the end of the day, a gut feeling. When it comes down to choosing between a higher risk investment with the potential for a substantial return and a more conservative investment, whose potential for losses may be lower but has a lower potential gain—that decision is a highly individual one.
For informed investors, a lot of research goes into making that final gut call. Understanding the components of risk tolerance—and risk itself—can help demystify it and assist in building a portfolio that parallels an investor's risk profile.
Investors aren’t just risk takers or risk averse. There are types of risk tolerance, and they can be broken down into three general categories that correspond to the amount of market risk an investor is willing to take on. Financial planners often gauge a potential client’s investment risk tolerance to understand how best to work with them to develop the right asset allocation.
An investor with an aggressive risk tolerance may be willing to purchase volatile securities for the possibility they’ll attain a high return. They might look toward small company stocks in emerging technologies or real estate. Aggressive investors are often active investors who research the securities they buy and, when the market takes big swings, they don’t lose sleep or sell in a panic. Their potential for returns is great, as is their potential for losses.
Investors with a moderate risk tolerance will often seek a balance between stocks and income-generating bonds. They’re likely to have an eye on diversification, balancing portfolios among asset classes and sectors. Moderate investors might split their portfolio 50/50 or 60/40 between stocks, mutual funds, and bonds. This approach means they’re likely not to get the same financial gains as aggressive investors when the market is up, but they’re also less likely to take a financial hit when the market falls.
Investors with a very low risk tolerance look for investments that are as low risk as can be, like bank certificates of deposits (CDs). The priority among those with conservative risk tolerance is to hold onto what they have—not to grow it at the risk of losing any of it. An example of a potential risk-averse investor would be a retiree whose portfolio is the culmination of years of work.
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Investors are often influenced by the priorities that are top of mind in their current phase of life. For instance, investors who are nearing retirement, living in a home that’s paid off, have a substantial nest egg, and no dependents will have a far different tolerance for risk than a mid-career individual with financial obligations and dependents. While there’s no precise formula for how to assess risk tolerance, investors can unpack these factors to get a clearer sense
Everyone wants and needs different things, and money facilitates many of those things. Rather than starting with the goal of making as much money as possible, financial advisors often suggest analyzing an investor’s goals, and then running the numbers to figure out how to achieve them.
A time horizon is how much time an investor has to reach their goals. Time horizon is generally defined as the period of time an investor is willing to hold an investment before they expect to sell and recognize a return. Those who have a longer time horizon have more latitude on risk: If they take a loss, they have time to make it up. An investor who needs a certain amount of money at the end of 20 years to achieve a goal (say, retirement) can take more risk than someone who needs money in two years to make a big purchase like a house.
In general, financial advisors would say that a retiree’s tolerance for risk couldn’t be as high as it would be for a mid-career investor. At 30 or 40, an investor still has time to ride out volatility and make it up in their job. On the other hand, if that retiree is a multi-millionaire, their tolerance might be very high.
The size of an investor’s portfolio can be a major determinant of how to assess their investment risk tolerance. The larger a person’s portfolio, the smaller percentage a loss may constitute in their overall net worth.
Here’s where an investor’s gut comes in. Would losing 10 or 20% of their portfolio destroy their peace of mind? Or would they see that drop as a buying opportunity? Do they need more perspective about the market and its historical performance to influence their tolerance?
An investor’s threshold may not be a perfect sum of all the factors listed above. Which is where talking to a financial advisor about how to balance investments might come in.
One person’s risk threshold, or personal comfort with the uncertainty of investing, is different from the risk an investor must take to achieve a financial goal. The latter idea describes risk capacity, which is a more objective idea than tolerance. Investors would look at the rate of return they’d need to achieve to meet a goal at a certain time. That information would help them figure out what type of investment to take on and how much risk they could afford to engage in.
The average historical stock market return since the S&P 500 Index began in 1929 is about 10%. But from 1929 to today, the market has weathered years that saw substantial consecutive drops, such as 2001 through 2003 (-9.11%, -11.98%, and -22.27%), but also years of big gains, such as 38.46% in 1975 and 38.02% in 1995. The net effect over nearly a century is that 10% gain. Investors can look at these historical returns to hypothesize how they would react in certain extreme market conditions—or in a sustained bull or bear market.
Understanding their personal mix of investment factors, the risks of playing it too safe or having a hair-trigger reaction to a change in the market, plus evaluating their own personality can help investors determine the best way for them to invest or rebalance their current portfolio.
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