What is Risk Tolerance?
Risks of investing and how to measure risk tolerance
Determining your risk tolerance is the first step to take before choosing the best investments for your financial goals. Once you know how much market risk you can tolerate, the next step is to begin building a portfolio that is suitable for your risk tolerance.
Risk Tolerance Definition
The investing terminology "risk tolerance" relates to the amount of market risk, such as the volatility, or market ups and downs, an investor can tolerate. Usually gauged by a calculator or questionnaire, financial planners often use risk tolerance to categorize investors and investing styles as aggressive, moderate or conservative.
Measuring Your Risk Tolerance
Your financial planner might offer you a risk tolerance questionnaire which will ask several questions about various market scenarios. You as the investor would anticipate your reaction to the given market scenario and answer the questions accordingly.
For example, a question might be, "What would you do if the stock market fell by 20 percent over the course of one year? You would a) Do nothing, b) Wait a few months to make a decision or c) Sell your stocks immediately."
An aggressive investor would likely answer 'a),' a moderate investor 'b)' and a conservative investor 'c).' The questionnaire aims to help the financial planner build a portfolio of investments that the investor will be comfortable with over long periods of time.
Abandoning an investment strategy abruptly due to unfavorable stock market activity does not typically serve an investor's goals, especially in the long run. The risk-tolerance questionnaire should aid the investor through anticipating and preventing poor investing behavior by choosing the right investment mix.
The Reality of Market Risk
Many investors make the mistake of believing they are "aggressive" when they are really "moderate," and when the stock portion of their portfolio falls dramatically in price, they sell the stocks immediately even if their previously gauged risk tolerance suggested they would "do nothing" during a severe decline in prices.
Although understanding your tolerance for risk helps, predicting or controlling your own behavior may present more of a challenge and be difficult to predict in advance. Being realistic with your preferences can help you make the right investment choices up front, rather than correcting later.
Risk Capacity vs Risk Tolerance
Risk tolerance involves a feature known as risk capacity, which identifies the amount of risk you can afford to take. This differs from the risk you are willing to take. In other words, you may be comfortable with an aggressive, high-risk portfolio but if you have only a few years to reach your investment goal, such as retirement, it may not be appropriate to have a portfolio of 100 percent stocks.
In this case, you might be better served with a more conservative, or lower-risk, portfolio to preserve the investment assets you'll need for retirement. For a better idea of your risk tolerance, try this risk tolerance questionnaire from Vanguard.