What You Should Know About Risk Tolerance

Risk tolerance is defined as one’s ability and willingness to tolerate large swings in investment value. While everyone’s appetite for volatility is different, the risks of not knowing one’s own specific tolerance are the same across the board. Take on too much and you might panic; take on too little and you may not reach your goals.

In this post, we’ll share all you need to know about risk tolerance and how it can impact your investments.

How your risk tolerance is determined

Three key drivers used to calculate your risk tolerance are your approach to market volatility, your time horizon, and your goals.

Your financial advisor will typically offer you some sort of questionnaire that asks several questions about various market scenarios to help determine how much risk you crave. Possible questions range from identifying how you’d react if the value of your investments fell by 15% over six months to where your comfort level falls between a range of potential investment outcomes.

Your investment time horizon (when you need the money) also matters when determining your risk tolerance. For example, investing a significant portion of your money in stocks would make more sense if you were saving for a far-off retirement than if you needed the money more imminently to buy a home. Generally speaking, the shorter the time horizon, the less risk tolerance one generally has.

Your investment objectives are another component of the risk tolerance equation. For example, younger investors are typically more inclined to take on additional risk, given their likely objective to grow the value of their portfolio. Other investors are perhaps content with the value of their investments and therefore aim to focus on preservation, which would reduce their risk tolerance.

Risk tolerance vs. risk capacity

Risk tolerance—how much risk you’re willing to take on—differs from your risk capacity, which measures how much investment risk you can actually accept given your financial situation. You must align these two components when investing because if you have an aggressive risk tolerance but lack the risk capacity needed to absorb a financial shock—such as a job loss or significant medical need—it would be much more difficult to overcome any investment losses, accordingly.

Types of risk tolerance

There are generally three risk tolerance levels: conservative, moderate, and aggressive.

Conservative investors are often focused on preserving their investments and more comfortable with lower returns in exchange for avoiding the risk of wild portfolio swings.

Moderate risk investors are comfortable with some risk, but with limits.

Aggressive investors are willing to take on more risk to potentially see higher returns and comfortable with investment portfolio volatility.

How financial advisors use risk tolerance

Your risk tolerance and risk capacity will guide your financial advisor in determining how to best allocate your money among different investments (also known as asset allocation). The higher your risk tolerance, the more likely your investments will weigh towards riskier investments such as stocks and real estate. If your appetite for risk is conservative, your financial advisor may recommend including stable investments—such as bonds or certificates of deposit (CDs)—in your portfolio.

Why you can’t ignore risk tolerance when investing

You may wonder how much risk tolerance actually matters when it comes to investing. Our answer? A lot!

You see, the biggest danger of investing with risk tolerance in mind is the propensity to act emotionally and make poor investment decisions—especially when markets are falling. As we’ve seen time and time again—most recently in March 2020 when the market tanked—panicked investors make rash decisions and sell off stocks because they can’t stomach additional losses. Consequently, many of these investors miss out when the market rebounds while others are forced to significantly alter their future goals. Therefore, not knowing and understanding your risk tolerance is one mistake you’ll want to avoid.

A perspective on risk tolerance and investing

Once in a while—especially during the search for a financial advisor—we hear someone compare his or her investment returns with those of a friend, co-worker, or family member. Now that you (hopefully) have a greater understanding of risk tolerance, including how it differs from person to person and its impact on investment decisions, you know why this exercise is usually meaningless.

In sum: risk tolerance and investing

Knowing your risk tolerance can minimize the chance you’ll make impulsive decisions due to market volatility. With that said, keep in mind that investments are only one component of your overall retirement plan; and when it comes to big life decisions such as buying a house, managing the death of a loved one, or tackling estate planning tasks, a financial advisor can help provide you with the clarity and guidance you need to make the best decisions.

Want to ensure your investments are aligned with your risk tolerance and goals? Get a complimentary portfolio review and risk assessment today from one of our CFP® professionals.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.