Risk tolerance is the “degree of change” in investment returns that an investor is willing to withstand. It’s a measure of how much risk you are willing to take on, and it can change over time. Risk tolerance has been on everyone’s mind lately, with the rocky road of 2022 and bounce back of 2023. It’s almost like investors forgot what volatility was between 2010-2020.
The first thing to understand is that risk tolerance is something that you have, not something that can be measured by a financial adviser or anyone else. It’s also important to note that your risk tolerance may change over time as your personal and financial circumstances change.
In theory, the higher your risk tolerance, the more volatility you can handle without going crazy.
Risk tolerance is a personal measure, not a universal one.
A high-risk investor will have a higher tolerance for losses over time than someone with low risk tolerance—and that’s okay! It’s important to recognize this because it can help explain why an investment strategy that may make sense for someone else might not be right for you.
The most important thing you can do is to be honest with yourself about your risk tolerance and then find investments that fit into that category. If you’re someone who has a high tolerance for risk, then consider investing some of your money in stocks. If you have a low tolerance for risk, then it might make sense for you to invest in bonds instead—or maybe even skip the market altogether by putting all of your money into cash or real estate.
Every investor needs to decide how much risk to take on when investing.
For example, if you’re saving for a down payment on your first home, you may want to put the vast majority of your money into no-risk strategies like CDs or online savings accounts (which are guaranteed by the banks up to FDIC limits).
On the other hand, if you have some time before retirement but still don’t have much saved up yet, it might make sense for you to put most of your portfolio in stocks because they could turn out bigger returns over time.
The key is knowing where each investment fits within your overall plan so that every goal gets what it needs from its own individualized portfolio.
Knowing your risk tolerance is key to choosing an appropriate portfolio.
Your portfolio’s allocation to stocks is a function of your risk tolerance. You might be risk-averse or risk-tolerant, but either way there are some general guidelines for what asset classes you should choose and how much of each you should hold.
The more risk tolerant you are, the more heavily weighted your portfolio will be in stocks (and other higher-risk assets like small cap equities).
If you’re conservative and have a low tolerance for volatility, your portfolio will have fewer stocks than someone who is less willing to stomach fluctuations in value over time.
During extreme positive or negative years, do not overcorrect
There are years during which your portfolio will suffer. It is a fact. You must know this ahead of time… However, these do not represent the norm; they are outliers. You should not panic or make changes to your portfolio in the middle of a market cycle because that is when things seem darkest and most confusing. Instead, take some time off, back away from the financial markets and gather your thoughts before making any decisions about selling or rebalancing.
Also avoid thinking of yourself as an active trader who sells because “the market has gone down too much.” This isn’t just bad practice—it’s almost always incorrect! In fact, by trying to sell early on companies whose prices have fallen below their true value (because they had been priced high), you could miss out on future gains from those same companies’ stocks going up again later on down the road if/when they recover from their low prices.*
The goal is to create a portfolio that’s in line with your goals, timeline and risk tolerance.
With that said, here are some questions you can answer to determine your risk tolerance:
- Do you like to gamble?
- Are you a saver or spender?
- How do you feel when your investments go down in value?
- How often do you check your account balances?
- Is your income erratic or consistent?
The more aggressive your answers are, the more likely you are an aggressive investor…but remember, being conservative or aggressive is not wrong or right… the whole point of knowing your risk tolerance is to match the right investments to your tolerance.
Risk tolerance is key driver of proper asset allocation and diversification decisions.
Risk tolerance is a key driver of proper asset allocation, and diversification plays a large role in managing risk. Diversification is important to all investors for reducing portfolio risk.
Diversification is crucial for long-term investment success. Risk reduction can be achieved by increasing the number and types of investments, as well as by strategically choosing an appropriate asset allocation (the balance between different classes of assets).
Investors should consider the following when diversifying a portfolio: – Investment objectives and risk tolerance – Time horizon for investment goals – Current financial situation
Risk tolerance varies based on age, income level, life stage and other factors.
Risk tolerance is a personal decision. It’s not the same as risk capacity, which refers to your ability to absorb losses. For example, someone who has a high tolerance for risk may be able to afford to lose money in an investment but doesn’t want to—he or she would rather hold onto the security of cash than take any chances with stocks and bonds. Someone with a low tolerance for risk might put all their money into stocks because they don’t want anything else between them and potential gains or losses (or both).
Tolerance can also vary based on your age, income level and life stage: Someone who is young may be willing to take more risks because he or she has time on his side; someone nearing retirement could be less willing because he or she doesn’t have many years left in which his money can grow before it’s needed for living expenses.
Final Thoughts
While risk tolerance is a personal decision, it’s one you have to make before you can move forward with your investment plan. To do that, take some time to think about what’s important to you — and how much risk you can handle. Then use that information to build a portfolio that suits both your needs and personality!
