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Updated on Monday, September 14, 2020
In investing, risk tolerance refers to the amount of risk an investor is willing to take on and how much loss they can stomach if the market sours. Unlike stashing your cash in a savings account, investing requires assuming a certain amount of risk, because your investments might rise or fall in value depending on market conditions.
Your risk tolerance is determined by a variety of factors, ranging from your time horizon to your personal comfort level. Read on for a full breakdown, and then take our short quiz at the end to help you to determine your risk tolerance level.
- Risk tolerance definition
- What factors determine your risk tolerance?
- What are the different risk tolerance levels?
- What’s my risk tolerance?
Risk tolerance definition
The Financial Industry Regulatory Authority (FINRA) defines risk as any investment-related uncertainty that has the potential to harm your financial welfare. Certain types of investments carry higher degrees of risk, and although taking on higher levels of risk might result in higher returns, it also could mean larger losses.
Risk tolerance generally is categorized into three basic levels: aggressive, moderate and conservative. Understanding your risk tolerance is a key component to investing, because it helps you to determine the appropriate asset allocation for your investment portfolio. Your asset allocation is how you divide your money among different asset classes, the most typical being stocks, bonds and cash.
If you can’t withstand potential large losses, for instance, you likely would benefit from investing in more-conservative assets and investments, such as bonds. On the flip side, if you can withstand large losses for the potential of bigger returns, you likely should opt for more-aggressive investments, such as stocks.
Risk tolerance vs. risk capacity
Risk tolerance shouldn’t be confused with risk capacity, which refers to the amount of risk you can afford to take, not how much risk you’re willing to take.
Your risk tolerance is determined by qualitative factors, such as your mindset and personality. Your risk capacity is based on more quantitative factors, such as the necessity for liquidity and your financial goals.
It’s important to understand your risk tolerance and risk capacity before determining your asset allocation. Some experts suggest letting your risk capacity drive your investment decisions, while factoring in your risk tolerance.
What factors determine your risk tolerance?
Several factors determine your risk tolerance, including:
- Time horizon: One of the most important factors to consider when determining your risk tolerance is your time horizon, which refers to the amount of time you have to invest and ride out any market highs and lows. Over the long term, the market has a history of trending upward, but it can be littered with lows in the short term. In a nutshell, time compresses risk.Those who have a shorter time horizon, such as older people close to retirement, tend to opt for more-conservative investments, because they don’t have as much time to allow market declines to bounce back. Younger investors, however, tend to have longer time horizons, so they typically are advised to take on more risk through aggressive investing.
- Financial goals: Your financial goals are a factor in determining your risk tolerance. After you determine the amount you must have to reach a specific financial goal, you can select an investment strategy that’s designed to yield the returns required to reach that goal, without taking on unnecessary risk.
- Portfolio size: The amount of money that you have to invest is another factor of your risk tolerance. Understandably, the more money you have to invest, the more risk you can afford to take on, because smaller losses won’t hurt as much. When you have less to invest, even small dips can have a big effect on your bottom line.
- Age: In many cases, your age is related directly to your time horizon. Younger investors, understandably, tend to have longer time horizons and can afford to take on more risk. Older investors have shorter time horizons and, therefore, can’t.
- Personal comfort level: Much of an investor’s risk tolerance is determined by their comfort level with uncertainty and the potential of financial loss. The more comfortable an investor is with the prospect of losing money in a financial downturn, the more risk-tolerant they tend to be.
What are the different risk tolerance levels?
There are three basic levels of risk tolerance: aggressive, moderate and conservative. After determining your risk-tolerance level, you can determine the right asset allocation for your investment portfolio.
The chart below features hypothetical performances for conservative, moderate and aggressive portfolios, according to Charles Schwab Intelligent Portfolios. These hypothetical portfolios provide an example of how the basic asset classes tend to make up portfolios for the three main risk-tolerance levels and the types of returns they typically generate. As you can see, the higher the risk, the higher the return — although, of course, past performance doesn’t guarantee future returns.
|Hypothetical Portfolio Performance for Different Risk Tolerance Levels|
|Hypothetical annualized return (1970-2014)||+8.1%||+9.4%||+10.0%|
|Hypothetical maximum loss (1970-2014)||-14.0%||-32.3%||-44.4%|
Source: Charles Schwab Intelligent Portfolios, based on data from Morningstar Direct on daily returns from Jan. 1, 1970, to Dec. 31, 2016.
What’s my risk tolerance?
It’s critical to determine your risk tolerance before you start building your portfolio. Doing so ensures that you create a portfolio that you’re more likely to stick with, despite market ups and downs.
Below is a quick risk-tolerance quiz based on a Rutgers study that will help you gauge your risk-tolerance level.