Risk Tolerance: What It Is and Why It Matters - MagnifyMoney

Risk Tolerance: What It Is and Why It Matters

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A “better safe than sorry” perspective can be an asset when crossing the street or making your annual physical appointment. But, unfortunately, it doesn’t bode well for your investments.

A better motto for investing is “nothing risked, nothing gained.” That’s why knowing your risk tolerance — that is, your comfort level with investment losses — is so important. Your answer will help determine which investments to use and in what proportion in your portfolio.

What is risk tolerance?

Let’s start with a risk tolerance definition: Risk tolerance is how much you’re willing to lose when making investment decisions.

When you invest, you’re betting that the money you put in today will be worth more in the future. So, typically, the higher the risk of an investment, the greater the potential returns over time.

To get a picture of how investments of different risk levels have historically performed, let’s look at some numbers from Vanguard for 1926 to 2019.

  • A portfolio invested 100% in fixed income (like certificates of deposit (CDs), bonds, bond funds, etc.) returned 5.33%.
  • A portfolio invested 100% in equities (like stocks, ETFs and mutual funds) returned 10.29%.

Fixed-income investments traditionally have lower short-term price volatility than equities, which makes them less risky overall. But to almost double your returns, you’d have to be willing to take on greater risk.

Why is risk tolerance so important for investors?

Your risk tolerance impacts your ability to reach your financial goals. Consider your retirement savings, for example.

Taking on too little or too much risk with your retirement investments could leave you with less money than you need down the road. If you haven’t thought about how much money you’ll need in retirement yet, don’t sweat it. Use our retirement savings calculator to run some calculations.

Risk tolerance is finding that sweet spot where you take on an appropriate amount of risk without putting your goals at risk. That sweet spot helps you determine your ideal asset allocation for your portfolio — how much of each type of investment you hold.

Levels of risk

Your risk level for investing is typically categorized as conservative, moderate or aggressive.

Conservative investors

You’re a conservative investor if you’re only willing to withstand minimal short-term losses with your investments. For example, say you’re nearing retirement or already in your second act. Then, to preserve your accumulated wealth, you may opt for lower-risk investments like bonds and CDs — and perhaps even some dividend stocks that can provide income even in down markets.

Moderate investors

If you’re a moderate investor, you still want to grow your wealth but might want to avoid the wildest short-term market swings. For example, if you’re 10 years from retirement, you might shift your asset allocation from 80% stocks/20% fixed income to 60% stocks/40% fixed income. With this less aggressive strategy, you can still enjoy some growth but potentially lessen the impact of market dips with a higher proportion invested in fixed income.

Aggressive investors

Calculated risk is probably your best friend if you’re an aggressive investor. Short-term market swings — upward and downward — are just another day in the markets because your eye is on the future. For example, say you’re an investor in their 20s who’s started to save for retirement. In that case, you might choose a 100% equities portfolio to capture the greatest possible growth in the decades ahead.

You may also see hybrid takes on these risk levels, like “moderately aggressive” or “moderately conservative.” And your risk tolerance can change over time depending on when you need to access your funds.

Risk capacity vs. risk tolerance

Risk tolerance is how much risk you’re willing to take, while risk capacity is how much risk you are able to take.

Your financial situation determines risk capacity. For example, if you’re a single, young investor with a stable income and no debt, you have a high risk capacity because you can afford to withstand the occasional bear market.

Conversely, if you’re someone with multiple obligations like a mortgage and family members who rely on you for financial support, your risk capacity is likely lower. You simply can’t afford a major financial setback.

However, risk capacity and risk tolerance aren’t necessarily related. For instance, you may be that young investor above but can’t stomach the thought of your portfolio losing 10% overnight. In that case, you have a high risk capacity but a low risk tolerance.

How to figure out your risk tolerance

You have two helpful methods you can use to determine your risk tolerance: an online risk tolerance quiz or answering a few questions about each investment you want to make.

Take a risk tolerance quiz

One of the easiest ways to figure out your risk capacity is to use a no-cost online quiz — often offered by online brokers or robo-advisors. For example, we like the risk tolerance quiz offered by the University of Missouri.

The quiz will ask you about specific financial scenarios to see how you might respond. Once you’ve answered all the questions, you’ll get a score that will translate to your risk tolerance. You can then use your score to start a conversation with a financial advisor or self-select investments that align with your preferred level of risk.

Answer investment-specific questions

Another way to determine your risk tolerance is on a per-investment basis. As you assess an investment opportunity, ask:

When will I need this money?

Also known as your time horizon, when you need the money impacts your capacity to withstand short-term losses.

Wise words: The shorter your time horizon, the less risk you can afford to take on. For example, if you’re saving for a wedding next year, you might consider low-risk investments like CDs and high-yield savings accounts since you can’t afford to lose those funds.

What are my investing goals?

An investor saving for retirement 30 years down the line and one who wants to preserve 30 years of retirement savings each have different capacities for near-term losses.

Wise words: Goals and time horizon work together to determine your risk tolerance. For example, you may be a long-term investor with a high risk tolerance with your retirement savings. However, you might choose conservative investments for money set aside for a house downpayment.

How healthy are my finances?

How would you react if one of your investments immediately lost 15% or more in value? Your overall financial health and net worth determine if you can weather a short-term loss or get stuck in the storm.

Wise words: You likely have a very low risk tolerance if you don’t have a healthy emergency savings account, since minor emergencies can have a massive financial impact. Conversely, you may be able to take on more risk if you have a healthy emergency fund and a significant nest egg. As a result, a short-term loss would have a much less significant impact on your overall financial health.

Now that you know about risk tolerance, what’s next?

Don’t let your financial education stop here. MagnifyMoney has a wealth of resources to help you build your wealth: