What is Risk Tolerance and Why Is It Important?
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 understanding your specific tolerance are the same for all. Take on too much risk, and you might panic; take on too little risk, and you may not achieve your goals.
In this post, we’ll share all you need to know about risk tolerance and how it can impact your investments.
Why risk tolerance is important
You may wonder just how much risk tolerance actually matters when it comes to investing. Our answer? A lot!
You see, the biggest danger of investing without risk tolerance in mind is the propensity to act emotionally and make poor investment decisions—especially when markets are falling.
As we’ve seen repeatedly—most recently when the market tanked back in March 2020—panicked investors often make rash decisions by selling off investments (primarily stocks) because they can’t stomach additional losses. Consequently, many miss out on significant returns when the market eventually rebounds (in 2020, for example, this happened rather quickly).
Understanding your risk tolerance is crucial, allowing your financial advisor to craft a strategy that balances market volatility concerns with the potential for higher investment returns: professional guidance that can give you peace of mind and confidence in your investment decisions.
Types of risk tolerance
Risk tolerance generally plays out across three levels: conservative, moderate, and aggressive.
Conservative investors often focus on preserving their investments and are more comfortable with lower returns in exchange for avoiding the risk of wild portfolio swings. Certificates of deposit (CDs), money market accounts, and bonds rank among investments often seen in conservative portfolios.
Moderate-risk investors, meanwhile, are comfortable with some risk but with limits: leading to a balanced mix of stocks and bonds within their investment portfolios.
Finally, aggressive investors are willing to take on more risk to potentially see higher returns and are thus comfortable with investment portfolio volatility. Investments such as real estate and stocks often comprise a significant portion of an aggressive investor’s portfolio.
How your risk tolerance is determined
Three key drivers used to calculate risk tolerance are your approach to market volatility, your time horizon, and your goals.
Financial advisors typically present clients with a questionnaire asking several questions about various market scenarios to help determine how much risk they crave; questions range from identifying how they’d react if the value of their investments fell by 15% over six months to where their comfort level falls between a range of potential investment outcomes.
Your investment time horizon, or when you’ll need to withdraw the money, is a crucial factor in determining your risk tolerance: providing reassurance and confidence in your investment strategy. For example, investing a significant portion of your money in stocks makes more sense if you’re saving for a far-off retirement than if you need 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 also play a significant role in the risk tolerance equation. For example, younger investors are typically more inclined to take on additional risk given a likely desire to grow their portfolio value; it’s this type of understanding that empowers you to make decisions aligning with your goals. Other investors, content with the value of their investments, may instead aim to focus on preservation and thus reduce their risk tolerance.
Risk tolerance vs. risk capacity
Risk tolerance, or the amount of risk you're comfortable with, is not the same as risk capacity: the amount of risk you can afford to take given your financial situation. It's crucial to align these two factors when investing.
For example, if you have a high risk tolerance but lack the risk capacity to handle a financial setback (e.g., a job loss or unexpected medical expenses), you may find it difficult to recover from investment losses—like feeling comfortable climbing into a rollercoaster car but potentially getting injured if you're not strapped in properly.
How financial advisors use risk tolerance
The combination of your risk tolerance and risk capacity will help your financial advisor determine how to best allocate your money among different investments. This process (asset allocation) involves spreading your investments across different asset classes such as stocks, bonds, and real estate. 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.
Perspective on risk tolerance and investing
Once in a while—often during the search for a financial advisor—we hear investors compare their investment returns with those of a friend, co-worker, or family member. Now that you (hopefully) understand risk tolerance a bit better, including how it differs from person to person and its impact on investment decisions, you can see why these comparisons are typically meaningless given extremely personalized circumstances.
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 give you the clarity and guidance you need to make the best decisions.
How to get a complimentary risk assessment
Want to learn your risk tolerance score and if you’re taking on too much risk? Schedule an appointment with one of our financial advisors and enjoy a complimentary risk assessment, mentioning this offer as the “reason for your meeting” when prompted.
FAQs
-
Investors comfortable with risk want to maximize the return on their investments and thus have a more aggressive investment strategy than their peers, often choosing stocks, real estate, cryptocurrencies (digital or virtual currencies such as Bitcoin and Ethereum), and/or commodities (funds that invest in various industries ranging from agricultural products and energy to raw materials such as precious metals).
-
It’s very likely your appetite for risk will change over time, particularly as life circumstances evolve per various milestones (e.g., getting married, having kids, earning a promotion, or nearing retirement). You should therefore address risk tolerance with your financial advisor on a periodic basis.
-
Recent studies label most Americans as risk averse. While there certainly isn’t anything inherently wrong with wanting to preserve and protect your investments, investors must strike the right balance of risk and return to—at a minimum—help protect them from inflation.
———
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.
There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal.
