Takeaways
- Risk tolerance determines your comfort in taking risks to achieve an investment return.
- Risk tolerance should be considered in the context of life milestones.
- Risk tolerance helps factors into your portfolio’s asset allocation and investment strategy.
- Risk tolerance is dynamic and can change depending on your personal situation.
- Risk tolerance ranges from the highly aggressive investor to the more conservative.
If you are a new investor trying to invest for the first time or an experienced investor looking to learn new things and refine your skills, you should be interested in determining your risk tolerance. Risk tolerance is a huge factor in crafting your investment portfolio (e.g., stocks, bonds, exchange-traded funds, certificates of deposit). We are going to dive into risk tolerance here so that you can get a clear understanding of what it is, how it works, the various types, and even how to apply your personal risk tolerance to your general investment strategy.
What is Risk Tolerance?
Risk tolerance, often also referred to as risk appetite, is a fundamental concept in investing, whether you are investing in stocks, bonds, or high-yield savings accounts. In short, risk tolerance refers to your ability, and ultimately your willingness, to weather fluctuations in the value of your investments. It’s about how much financial risk you are comfortable shouldering without losing sleep.
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Think about risk tolerance as a spectrum. On one end, there are the high-return and high-risk investments, and on the other end are the low-risk and low-yielding investments. Where you are on the spectrum is usually dictated by where you are on traditional life milestones.
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Your personal risk tolerance is a unique blend of your financial ability to withstand losses and your emotional capacity to endure uncertainty. Having a clear and honest grasp of your risk tolerance is critical for effective investment. It will help guide your decisions and help you choose the right mix of assets for your portfolio while keeping your overall investment strategy aligned with your long-term financial goals.
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Types of Risk Tolerance
There are three common buckets, or levels, of risk tolerance. Typically, younger investors tend to start closer to the beginning of our list with more aggressive investing strategies, while those nearing retirement will often adopt a more conservative approach. Here are the three main buckets of investor risk tolerance:
1. Aggressive
If you possess an aggressive risk tolerance, you aim for high returns and are comfortable with significant risk. You might invest in growth stocks, emerging markets, or other high-risk, high-reward assets. This approach is often adopted by younger individuals with longer investment horizons or a higher financial capacity to absorb losses.
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2. Moderate
With a moderate risk tolerance, you seek a balance between risk and return. You are willing to take on some risk for higher potential returns, but not to the extent of jeopardizing a significant portion of your capital. A balanced and diversified portfolio of bonds and stocks might appeal to you.
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3. Conservative
If you have a conservative risk tolerance, you prefer safe investments with lower potential returns but also lower potential for loss1. You may favor bonds, certificates of deposits, money market accounts, or other low-risk investments. This approach attempts to preserve capital and is incredibly common among individuals nearing retirement or others with shorter investment time horizons.
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Even though there are three well-defined types of risk tolerance, it’s important to remember that it’s a spectrum. You may be more aggressive with some types of investments while being more conservative with others. The critical thing to remember is finding what’s best for you.
Risk Tolerance Factors
Countless factors can impact your risk tolerance. Understanding them can make you a better investor. Your existing financial standing, encompassing your income, savings, and debt, lays the groundwork for the level of risk you can reasonably bear. At the same time, your investment goals steer your risk tolerance.
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Your investment time horizon, investment knowledge, and experience also mold your risk tolerance. A longer investment timeframe often permits a higher risk tolerance as it provides more room to recover from potential market downfalls. Finally, your age and the prevailing economic conditions are also critical in forming your risk tolerance, with younger investors typically having higher risk tolerance than older investors.
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Risk Tolerance And Your Investments
As we’ve discussed, your risk tolerance has an immense impact on your investments, and having a better understanding of that tolerance can help you strategize more effectively regarding asset allocation and risk management. It will help guide your asset distribution during investment, helping to determine your unique assortment of stocks, target date funds, bonds, and more.
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Not only that, but your risk tolerance also informs your risk management strategies, guiding how you protect your portfolio from potential losses. This means that by aligning your overall investment approach with your personal risk tolerance, you can begin to create a roadmap to your financial goals that doesn’t involve pulling your hair out during market shifts.
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Smart Summary
Everyone has a level of risk tolerance, and you should figure out what yours is today. A mismatch between your risk tolerance and your investment portfolio could deliver a misalignment of expectations. For example, if you have a high risk tolerance and all your cash is parked in your savings account or checking account, you need to deploy your investment funds in equities like mutual funds, index funds, and individual stocks. Determining your risk tolerance and regularly monitoring it based on your life milestones is a smart money move.
(1) U.S. Securities and Exchange Commission. Assessing Your Risk Tolerance. Last Accessed March 1, 2024.
