What Is Risk Tolerance?
Definition & Examples of Risk Tolerance
Measuring and 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, you can choose suitable investments that match your risk profile.
Learn more about risk tolerance, how to assess yours, and the role it plays in putting together your investment portfolio.
What Is Risk Tolerance?
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.
Every investor needs to gauge their risk tolerance before choosing their investments. With knowledge of your risk tolerance, you'll have a better idea of which investment types are suitable for you and which investments you should avoid.
Those who have an aggressive risk tolerance would want to focus more on stocks, while conservative investors would likely focus on bonds and other fixed-income investments, primarily government-issued bonds and investment grade municipal and corporate bonds. Without this knowledge, it becomes hard to construct a portfolio that fits your financial goals.
How Risk Tolerance Works
If you have a financial planner, they 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 inquire about your response to the stock market falling by 20% and the resulting possible actions: Do nothing, wait a few months to make a decision, or sell your stocks immediately.
An aggressive investor would likely do nothing; a moderate investor might wait a few months to decide; a conservative investor might immediately sell their stocks. 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. The idea is to prevent an investor from abandoning their financial goals by selling an investment due to market volatility.
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 help the investor through anticipating and preventing poor investing behavior by choosing the right investment mix.
Generally, the younger you are, the more risk you can take on because you'll have more time to recover from downturns in the market. Investors with at least 10 years until retirement commonly focus on growing their investments, while those retiring in a few years often focus on capital preservation—resulting in aggressive and conservative risk tolerances, respectively.
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 example, 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 is certainly not suitable to have a portfolio of 100% stocks.
Even if you are far away from retirement diversification among asset classes, including stock and bonds, is required in investments. In this case, you might be better served with a more conservative portfolio to preserve the investment assets you'll need for retirement.
Criticism of Risk Tolerance
Although risk tolerance is a vital part of any investor's financial planning, problems arise when someone misjudges their tolerance. Many investors make the mistake of believing they are aggressive when they are 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 upfront, rather than correcting later.
- 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 usually take on more risk because they have more time to recover from volatility.
- Aggressive portfolios contain mostly stocks, while conservative portfolios focus on bonds and fixed-income investments.