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Risk Tolerance: What to Know

Before investing, it’s important to know what your risk tolerance is. In this article, we explain what it is and how you can determine it.

Risk is an inevitable part of life and finance. In the latter, one must take a certain degree of risk if they invest for either sustained or expansive growth. However, the amount of danger someone is willing to tolerate varies greatly from person to person.

In the world of investing, there are many approaches to building your portfolio. Generally, these strategies are dictated by both your goals and risk tolerance. This article will detail how the latter concept works, including the specific categories people fall into. You’ll also learn why risk tolerance is important to your investing journey and how financial advisors use it to assist you.

Risk Tolerance Definition

Whenever you invest in a security, such as a stock or bond, you assume the risk that you’ll lose some or all of your money. But, while this danger is always present, some investments pose more than others in return for higher growth. Because of the varying risks with certain investments, it’s up to you to decide how much you’re willing to tolerate in accordance with your goals and time horizon.

Risk tolerance is a crucial guiding force to one’s investment portfolio and financial plan. It helps you determine which investments you should invest in and how long you should hold onto them. For example, consider a person in their late 50s who’s looking to retire in five years. Because they’re close to their goal, they may only tolerate minimal risk because they don’t want to lose what they’ve already built up to this point.

As we’ll touch on in the next section, there are varying levels of risk that people may be willing to take on. Those who are willing to put their money in more peril do so because they could see larger returns. On the other end of the spectrum, one may invest conservatively, only seeking small, sustained returns over a long period.

Understanding your risk tolerance is essential to your financial and investment path. Without it, it’ll be more difficult for you to weigh whether a given security is right for your portfolio. Additionally, it will make it more difficult to convey your needs to financial advisors. By understanding what you’re able to bear, you’ll be able to invest and communicate more decisively.

Levels of Risk Tolerance

Unlike some other concepts, risk tolerance isn’t necessarily binary. Rather, there are varying degrees of what people are willing to handle. A good way to think about it is as a spectrum, ranging from conservative to aggressive, with more moderate approaches in between. Below is a list of common levels financial advisors use:

  • Conservative. With this approach, you’ve determined that you would like to minimize risk as much as possible, even if it diminishes your returns. By doing so, your portfolio remains stable and isn’t as susceptible to fluctuations.
  • Moderately conservative. With this mindset, you’re aiming to remain relatively safe from risk, but also see a bit more growth in your investments.
  • Moderate. This middle-ground approach seeks to blend risk and reward. While you may not want to be aggressive, you still would like to see growth throughout your portfolio.
  • Moderately aggressive. Here, you’ll turn the risk potential up a notch for the chance at higher returns. This requires you to be comfortable with a substantial amount of fluctuation in your investments.
  • Aggressive. This assumes you’re willing to accept the highest level of risk for the greatest possible returns. In this case, you should be comfortable with the chance that your investments go to zero.

To help you visualize the different degrees of risk tolerance as a spectrum, consider the following graphic:

Degrees of risk tolerance

Advisors or portfolio managers will often use the above categories (or similar ones) to help you devise an overarching investment strategy and financial plan. This includes working with you to come up with an asset allocation and diversification plan that fits your needs. These are risk management strategies that emphasize spreading your funds across various asset classes (and the securities within) to blend risk and reward as necessary.

Determining Your Risk Tolerance

Before you begin investing, it’s important that you determine your risk tolerance. This will help you as you develop an investment strategy, either alone or with an advisor. According to Robert R. Johnson, PhD, CFA, CAIA, and Professor of Finance at Creighton University, “One’s risk tolerance is a function of two concepts — one’s ability to bear risk and one’s willingness to bear risk.” That is, the resources you have and how you handle risk psychologically each play a key role in your overall tolerance.

Johnson explains that one’s willingness to “bear risk” is harder to identify than one’s “ability to bear risk.” This is because the former is largely up to each person’s comfort with putting their money and, by extension, themselves in a position to lose. On the other hand, a person’s ability to handle risk is up to what they have at their disposal, as well as their time horizon.

“Trying to determine one’s willingness to bear risk is problematic,” says Johnson. Financial advisor firms typically try to gauge a client’s point of view by “posing the question – ‘would you be able to handle a downturn of 20%, 30%, or 40%, etc. in your portfolio’s value?’.” But, according to Johnson, someone’s hypothetical answer and what they’d do in real-life circumstances are “two different concepts.”

Ultimately, to determine your risk tolerance, you need to consider whether you can both handle risk financially and mentally. There are, however, some questions you can ask yourself that can assist you here:

  • What are your goals? In other words, what specific financial or investment benchmarks are you trying to achieve? This impacts your ability to bear risk because certain goals may necessitate different levels of risk.
  • How soon do you need to reach your goal? Your time horizon will inform how much risk you’ll be able to take. For instance, someone with several decades until they retire may afford to take more risk than one who is closely approaching it.
  • Are you financially able to handle a significant drop in your investments this year? As Johnson points out, this is a problematic question because it doesn’t quite get to the essence of your willingness to bear risk. However, it does get you thinking about what you would do in such a scenario, which can hint at how you feel about risk.

How Financial Advisors Use It

If you work with an investment management firm or a robo-advisor, you’ll usually need to provide information about your risk tolerance. Many companies or professionals will place you in categories similar to the above. And, after pairing this with your goals and time horizon, they’ll either provide recommendations or trade on your behalf based on your preferences.

As you sign up for an account with a given firm, you’ll typically need to answer specific questions that point to your willingness and ability to bear risk. Per Thomas Brock, CFA, CPA, this includes questions like “Do you have a steady stream of income that covers your day-to-day expenses and facilitates savings?” or “How much money are you willing to lose on your investments? Do you feel the same if you could get it back in a year or two?” Once an advisor has this information, they’ll be able to recommend securities more effectively or construct a portfolio that matches your preferences.

Frequently Asked Questions

What happens to your risk tolerance over time?

Throughout your life, your risk tolerance may change as your views and circumstances shift. The former is harder to quantify because it’s up to individual preference and development. However, stages in your life, such as being married, having children, or retiring, can affect your ability and willingness to bear risk.

What are the three factors of risk tolerance?

Financial advisors often try to gain an understanding of your risk tolerance by ascertaining your goals, time horizon, and how you would handle a significant market drop. The third factor tells an advisor where your head is at when a crisis happens, i.e., do you sell or weather the storm by holding what you have? However, according to Johnson, this question only gives professionals limited information because it’s purely hypothetical.

How do I know what my risk tolerance is?

You’ll need to assess both your willingness and ability to accept risk to figure this out. The former is up to preference and your mindset regarding putting your money in danger. For this reason, it’s not as easy for professionals to assess their clients. The latter, however, refers to your financial capacity to handle losses. Your goals and time horizon play a key role here because they dictate what your needs are.

What securities do aggressive investors buy?

Those who would like to aggressively grow their portfolio’s value tend to take large risks to do so. This typically involves betting on specific equities or, if one is able, investing in alternatives, such as hedge funds. Conversely, those looking to grow their portfolio more conservatively gravitate toward securities that generate sustained returns over time, such as mutual funds or bonds.