What Is Risk Tolerance?

Definition & Examples of Risk Tolerance

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As you've heard or read in many a disclaimer: All investments carry some degree of risk. But in the silent subtext of that statement is the other half of the equation: Can you handle it? Or to put it another way: Is the amount of money that you stand to lose worth the risk in this case? A big part of that answer will be about your comfort with taking risks with your money. Your own risk tolerance depends on many factors, both personal and financial. If you're new to investing, as a first step you should measure and learn about your risk tolerance before choosing the best investments for your financial goals. Once you know how much market risk you can tolerate, you can invest in line with your values and comfort level, and build a portfolio that matches your risk profile.

Learn more about risk tolerance, how to assess yours, and the role it plays in creating your investment portfolio.

Key Takeaways

  • Risk tolerance is the amount of market risk an investor can withstand.
  • Financial planners often categorize risk profiles as conservative, moderate, or aggressive.
  • Younger investors often take on more risk because they have more time to recover from market swings.
  • Aggressive portfolios contain mostly stocks, while conservative portfolios focus on bonds and fixed income assets.

What Is Risk Tolerance?

Risk tolerance relates to the amount of market risk an investor can tolerate. In simple terms, it is how much you are willing to be unsure about (and how much money you're willing to spend on this unknown), in the face of possible gains. Risk itself comes in many forms, such as the volatility of a certain stock, or full market ups and downs. Financial planners often use a person's risk tolerance to get a feel for what to expect from them as a new client, and vice versa. They can also use risk tolerance to assign their clients' investing styles as aggressive, moderate, or conservative. Or, your advisor may take it further than a simple breakdown, and build a full risk profile of you to help them better invest on your behalf.

The Three Standard Levels

To keep things simple, you'll often see risk tolerance presented as one of three standards. You may fall neatly into one of these, or you may straddle two, or you may find that you move between all three as you enter a new stage in your life. (Most people do.) Firms also use the three standards as a shorthand way to describe asset options, to suggest asset allocations, or to offer strategies to their clients. On a scale from least to most risky, these are:

  • Conservative: They prefer to feel safe in how they choose to invest. They would rather avoid the risk of loss than take a chance on major gains. They tend to be older, and less wealthy than others.
  • Moderate: They can take on some risk, but within bounds they have thought about. They may be willing to lose a portion of their money on the chance to make big gains, but will not risk more than they can afford to lose.
  • Aggressive: They can take big risks on new ventures, stocks, and other less stable assets. They can handle major ups and downs in values and prices. They could have huge wins, and could also suffer major losses. They tend to be more wealthy and can afford to lose more money than others, or quite young with time on their side.

Every investor needs to gauge their risk tolerance before choosing their investments. With this knowledge you'll have a better idea of which investment types work for your level of comfort, and which you should avoid. Without this knowledge, it becomes hard to construct a portfolio that fits your profile and meets your goals.

The standard practice is for those who have an aggressive risk tolerance to focus more on stocks, while conservative investors would do better to focus on more stable assets, such as bonds and other fixed income assets.

How to Assess Your Risk Tolerance

You can gauge your own level of risk with an online calculator or by talking to a financial planner. If you have a financial planner, they might have tools of their own. Tests come in a wide range of styles, from the basic test of 20 yes/no questions, to a very detailed questionnaire that asks you to predict how you might behave in the market, and also about how you approach risk in other parts of your life as well. In the latter you may be asked to rate your reaction to the given market (or out of market) scenario on a sliding scale, and answer complex questions that make you think about the way you handle money and risk in all parts of your life.

For instance, a question might ask how you would respond to the stock market falling by 20% and offer a few sample actions: do nothing, wait a few months to decide, or sell your stocks promptly.

An aggressive investor would most likely do nothing; a moderate investor might wait a few months to decide; a conservative investor might sell their stocks right away. The questionnaire aims to help the financial planner build a portfolio of assets that will match your comfort level and needs over long spans of time. The idea is to keep your investing progress on track, in spite of how you react to single upsets. Being aware of your risk tolerance, and building a portfolio with that profile in mind, can prevent you from abandoning your financial goals by selling or acting on impulse due to market volatility.

There are many factors that affect your risk tolerance, and comfort level is just one of them. Advisors will also look to your age, your goals, how these create a timeline, and the size of your portfolio.

Common Patterns in Risk Profiling

For the most part, the younger you are, the more risk you can take on. This is simply because you'll have more time to come back from downturns in the market. Investors with at least 10 years until they are due to retire often focus on growing their investments, while those who plan to retire in a few years often focus on preserving capital. The former depicts a more aggressive risk tolerance, while the latter is more conservative.

Risk Tolerance vs. Risk Capacity

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. For instance, you may be fine with an aggressive, high-risk portfolio, but if you have only a few years to reach your goal, it does not suit your best interest to have a portfolio of 100% stocks.

Let's look at this in practice. Suppose you have just started a new career, and are planning to retire in 40 years. Your income is on the low side, and you have nothing in savings. But your cost of living is low, and you're young, so those things will come in time. Suppose also that it's in your nature to play big, roll the dice, and take leaps when given the chance. (Or in other words, you are risky by nature.) You may tell your financial planner you have nothing to lose, and to put it all in stocks.

Given all these details, it makes sense that you'd go for a more aggressive approach. But, your income and savings are low, so you may not be able to weather a severe price drop in your stocks. Also, you may not have thought about the higher cost of living in a few years when you decide to move or start a family. Lastly, even though you have decades before you retire, it is still wise to have a diverse portfolio. Diversification among asset classes, including stock and bonds, is, for most, a must. So while on a personal level you may be fine with a great deal of risk, your capacity for risk is lower (and still aligned with common wisdom). In this case, you might be better served with a more conservative portfolio than you desire, to preserve the assets you'll need to retire.

In many studies, men tend to have higher risk tolerance than women, but only slightly. Many experts think this is an effect of each group's level of training and comfort with the market, rather than gender.

Criticism of Risk Tolerance

Although risk tolerance is a vital part of any financial plan, many people do not use it as much as they should. If you misjudge your risk tolerance, or go against what you know to be true about yourself, this is when problems arise. Many investors make the mistake of thinking they are aggressive when they are moderate. Then, when the stock portion of their portfolio takes a drastic fall in price, they sell the stocks right away, even if their previously gauged risk tolerance suggests they would "do nothing" during a severe decline in prices.

Although understanding your tolerance for risk helps, predicting or controlling your own actions in the face of an upset may present more of a challenge and be difficult to predict in advance. Being realistic about how you want to invest can help you make the right choices upfront, rather than feeling regret, or having to correct them later.

Article Sources

  1. CFA Institute. "Risk Profiling and Tolerance: Insights for the Private Wealth Manager," Pages 6-9. Accessed Aug. 22, 2021.