What is risk tolerance?
Risk tolerance is the level of risk you are willing to take as an investor.
In finance, there’s a strong relationship between risk and return. The greater the risk, the greater the range of possible outcomes—higher highs and lower lows. But, assuming you can withstand the ups and downs of the market, taking more risk can result in higher returns over long periods.
As an investor, you must determine how much risk you are willing to take with your investments. This article will discuss which factors you can use to assess your risk tolerance and explore three of the most common risk tolerance profiles. Then, we’ll discuss how you can evaluate your risk profile as an investor.
What factors determine your risk tolerance?
The amount of risk you take will determine the possible range of outcomes you can expect as an investor. But, how much risk should you take? That depends on the following factors:
Time horizon & Age
The most crucial factor to consider when determining your risk tolerance is your time horizon, which is often directly tied to your age. For example, when you’re in your 20s, 30s, and even 40s and investing for retirement, you’ve got decades to let your investments grow and compound before you retire. That’s also decades that your investments have to recover in the case of a market correction or recession.
So, with time on your side, most financial professionals recommend taking a more aggressive investment approach. This rationale is a good fit for most people as it will often result in higher returns over time, giving you a greater chance of achieving a secure retirement.
But, if you’re in your 50s or 60s, it is often best to begin lowering your risk tolerance to avoid significant losses or market corrections as you approach retirement age. And for those in retirement living off their nest egg, a conservative risk tolerance is usually best.
Next, when you’re investing for a specific financial goal, like your child’s future college expenses or to buy a rental property, it is essential to match your risk tolerance to the particular goal.
For example, if you’re in your 30s and have an aggressive risk tolerance for your retirement funds, but are setting up a 529 college savings plan for your 6 year old child, you may decide to take a less aggressive investing approach for the college plan, as your child will need the funds in the next 12 years. This will help you reach your financial goals while also reducing the risk of losses as you approach your financial goal deadline.
Another factor to consider is the size of your portfolio. Often, investors find that the larger their total portfolio, the less willing they are to embrace risk. That’s because a 10% drop on a million-dollar portfolio ($100,000 loss) can be tougher to stomach than a 10% drop on a 100,000 portfolio ($10,000 loss).
For that reason, many investors choose to lower their risk tolerance as the total value of their portfolio increases.
Lastly, you must consider your personality when determining your risk tolerance. For example, if you’re comfortable watching your investments fluctuate dramatically with the market, you may be okay taking above-average risks. But, if you would lose sleep because of market volatility, it may be best to take a more conservative investment approach. And even if that means lower returns over time, the most important thing is that you stay invested for the long term while sleeping well at night.
What are common risk tolerance profiles?
Financial professionals typically group risk tolerance profiles into the following three categories:
Conservative investors are often in their late 50s or older, either in or approaching retirement. These investors aren’t interested in taking high risks because they cannot afford to have their portfolios fluctuate dramatically in value. In addition, younger investors with a risk-averse personality, large portfolio, or short-term financial goals may fall within the conservative risk profile.
While exact recommendations and portfolios can vary widely based on your unique situation, most conservative investors have roughly 30 to 60% of their portfolio in stocks and the remaining 70 to 40% in bonds. The higher allocation to bonds helps smooth out the portfolio’s volatility, resulting in lower overall returns, but lower potential losses.
Moderate investors are often in the mid to late stages of their career, in their 40s or 50s, and are approaching retirement in the next 10 to 20 years. These investors are still seeking solid returns but have chosen to limit those returns in exchange for less volatility in their portfolio. In addition, younger investors with a more moderate risk personality, medium-term financial goals, or a large portfolio may fall within the moderate risk profile.
Again, exact recommendations and portfolios will vary widely. Still, many moderate investors will have somewhere between 50 to 80% of their portfolio in stocks, with the remaining 50 to 20% of their portfolio in bonds. Additional exposure to bonds helps smooth out volatility, but it is not so much that it stifles returns. That way, moderate investors can avoid extreme swings while still earning solid returns.
Aggressive investors are often in their late teens, 20s, and 30s, with decades to save and compound their investments for retirement. This group is comfortable taking higher risks in exchange for higher returns over the long run. They’re also comfortable watching their portfolio drop dramatically during market downturns. This is not a great fit for all young investors—those with a more risk-averse personality, short-term financial goals, and larger portfolios may choose to reduce their risk accordingly.
A typical aggressive portfolio may consist of 70 to 100% in stocks, with the remainder of the portfolio in bonds. However, it’s important to note that the exact mix of stocks to bonds suitable for you will depend on your unique situation. Aggressive investors often seek to maximize returns over the long run, even if it means significant volatility in the short run.
How to determine your risk tolerance?
To determine your risk tolerance, evaluate your age and time horizon, financial goals, portfolio size, and personality to decide your risk profile. In addition, it may help to take a risk tolerance survey and work with a financial professional to determine how much risk to embrace. Finally, wherever you land, remember that your risk tolerance will change over time, and it should be a continuous piece of your financial planning process.