Risk tolerance is your ability and willingness to tolerate a decline in the value of your investments. When trying to determine your risk tolerance, ask yourself how comfortable you will feel maintaining your positions when the stock market experiences big declines.
There’s an old Wall Street saying that goes, “You can either eat right or you can sleep right.” Eating well refers to the observation that holding higher-risk assets (such as stocks) over a long time horizon allows investors to amass significant wealth. However, that comes at a price, as stocks can be quite volatile, causing some investors to lose sleep.
“Every investor is unique, and finding your position on the risk spectrum is an important step in building a successful investment strategy,” said Miles McQuillen, assistant vice president of the private wealth management team at Gabelli Funds.
Why risk tolerance is so important
Your risk tolerance plays a crucial role in your game plan to grow your money without worrying about it every day.
If you don’t have the courage to deal with the risks of losing your principal, even temporarily, you will have to settle for lower-risk investments and the lower returns that come with them. Investments with the potential for higher returns often offer a greater chance of sudden downturn or outright loss.
Understanding your risk tolerance can help you create a strategy for your investments that helps you balance concerns about volatility with the potential for greater returns.
How risk tolerance works
Anyone can have a high risk tolerance when stocks rise. However, the best time to really assess your risk tolerance is when the market is falling.
Think back to March 2020. The market plummeted. Unemployment rates soared. The world faced unprecedented levels of uncertainty and wondered whether COVID-19 would destroy the economy.
What was your risk tolerance then? Did you persevere during those difficult times? If you sold stocks during the panic, your risk tolerance was low. Or were you willing to invest more to take advantage of the market sell-off? If so, then your risk tolerance was high, and that has served you well as the stock market reached record highs in 2023.
Your risk tolerance may have been tested again in 2023, as rising interest rates sent stocks and bonds plummeting. Some of the most speculative stocks fell more than 80 percent from their highs as investors reassessed company valuations and worried about a possible recession.
Types of risk tolerance
There are a few different types of risk tolerance.
Conservative risk tolerance
With this mindset, an investor is focused on preserving capital and avoiding downside risk. That means a lower return, but the investor will settle for that in exchange for avoiding wild value swings. For example, a certificate of deposit (CD) is a very conservative investment. A bank or credit union guarantees a certain return in exchange for keeping an investor’s money locked up for a predetermined period of time. The promise of returns is an advantage, but the low earnings potential (CDs historically earn much lower returns than stocks and real estate) can be a disadvantage. An older investor closer to retirement will likely have a fairly conservative risk tolerance.
Moderate risk tolerance
Moderate risk tolerance holds its ground in two camps: conservative and aggressive. A classic example is the traditional 60/40 allocation between stocks and bonds. This balances some of the money invested in growth (stocks) while maintaining stability for income generation (bonds).
Aggressive risk tolerance
An aggressive risk tolerance allocates the majority of an investor’s portfolio to riskier assets such as stocks and real estate. These offer the prospect of higher returns in the long term. However, that time component is an important ingredient. The investment has a greater chance of losing value along the way and there is no guarantee that an investor will actually get the money back. Being aggressive means that you are willing to accept the chance that you will lose some or all of your principal.
How to determine your risk tolerance
Determining your risk tolerance depends on answering a few key questions:
- What are your investment objectives? Do you invest regularly and want to grow the value of your savings? Or do you already have a decent nest egg and would you rather keep it than let it grow and live off the income it generates? Each of these will carry a different tolerance for downside price risk.
- When do you need the money? Your time horizon is a crucial part of the equation. The sooner you need the money, the lower your risk tolerance should be. Money you’ll need for a down payment on your house next year has a completely different time horizon than the money you’ll accumulate for retirement, which is still years away.
- How would you react if your portfolio lost 20 percent this year? When assessing your risk tolerance, think about hypothetical challenges and worst-case scenarios. If your investment lost 20 percent of its value, would you lie awake at night withdrawing all your money? Or would you leave it invested and consider putting even more money into the market to take advantage of the discount?
How investment experience relates to risk tolerance
What is your experience with investing? As you determine how much risk you can handle, it’s also important to consider how much knowledge you have of the investment landscape. It has never been easier for someone to open an online investment account and pick stocks and other investments for themselves, but that convenience can also be very costly.
Online chatter can create momentum around stocks and other investments, fueling uninformed buying and selling by inexperienced investors, leaving them vulnerable to significant losses. So be honest with yourself about your level of expertise. And as you start investing your money, make sure you invest your time in increasing your financial knowledge.
“It’s about tailoring your investments to your financial goals, emotional resilience and knowledge level,” says McQuillen.
Risk tolerance versus risk capacity
It is important to assess your risk tolerance in relation to your ability to take risks. These two components must be coordinated.
For example, if you’re a 20-something saving for retirement in your workplace 401(k), you have a large capacity for risk. You may have 45 or 50 years until retirement, which means you can afford to invest aggressively with the capacity to withstand the potential of a decline in value. However, your risk tolerance may not match that. Maybe you are a nervous investor.
Thinking about risk in the big picture
When you are just at the beginning of your career and starting to invest, it is important to take a long-term view. It can be difficult to see your investments drop overnight. However, if you don’t invest that money until tomorrow or next month, you need to realize that it’s the end game that really counts.
The stock market may average a 10 percent annual return over time, but it doesn’t deliver those 10 percent gains every year. Some years the price may have fallen by more than 30 percent, while in other years it may have risen by more than 30 percent. Measure the growth of your returns over time – not every day. As you get closer to retirement, you should take a closer look at your ability to handle downside risk. Be sure to reevaluate your risk tolerance and risk capacity to make necessary adjustments.
In short
Risk tolerance is your ability and willingness to tolerate fluctuations in the value of your investments. Everyone’s risk tolerance is different and is influenced by multiple factors, including your time horizon, your knowledge of the markets, and your financial goals. Understanding your risk tolerance can help you choose investments that fit your financial priorities without waking you up at night.
