When it comes to risk in investing, the question isn't "if" — it's "how much." Discover here what risk tolerance is and how it shapes your investment strategy and portfolio.
6 min read
We’ve said it before, we’ll say it again: All investing involves risk. Whether you’re investing for the first time or you’ve got your strategy down to a science, your personal risk tolerance is always part of the equation. But what is risk tolerance in investing, exactly? And how much risk are you willing to take on to achieve your financial goals? Answering these questions is important, especially before you start investing. Once you understand your risk tolerance, you can set realistic investment goals and craft an investment portfolio that aligns with your budget, personality, and values. In this article, we break down what risk tolerance in investing means and how you can figure out your own level of risk tolerance.
What is risk tolerance?
In simple terms, risk tolerance is how much risk you’re willing and able to take. Or, as the U.S. Securities and Exchange Commission (SEC) defines it, risk tolerance is “an investor’s ability and willingness to lose some or all of an investment in exchange for greater potential returns.” Some investors may be comfortable with making high-risk investments — for them, the possibility of hefty returns is worth it. But others prefer safer, more stable options, even if it means they might earn less on their investment.
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How does your risk tolerance impact your investment strategy?
Your risk tolerance fundamentally shapes your investment strategy. If you have high risk tolerance, you might take a more aggressive approach, such as investing in stocks. Or, you could choose to put your money into emerging markets — you’ll probably see prices move around drastically, but you might end up with large returns. On the other hand, if you have low risk tolerance, you’ll probably choose a more cautious, conservative strategy. That could involve for example investments like bonds or index funds that offer stability and steady, modest returns. The key is to balance your risk profile and goals to — hopefully — succeed financially without sacrificing your peace of mind.
What factors influence risk tolerance?
Several key factors determine your risk tolerance in investing, and each play a different role in shaping how much risk you’re willing to take. Here’s a breakdown of some of the most important factors:
Age: Younger investors often have higher risk tolerance because they have more time to recover financially from market downturns. As people approach retirement, their risk tolerance tends to decrease.
Time horizon: Your risk tolerance also depends on how long you plan to invest, or if there’s a deadline for any of your goals — for example, to retire by a certain age. A longer time horizon allows for more risk, as there’s more time to ride out volatile markets and let your money grow as much as possible. Investors typically have lower risk tolerance with short-term goals.
Financial goals: Your specific financial goals also shape your risk tolerance. Let’s say your primary focus is saving up to buy a home. In that case, you'll likely prefer lower-risk investments that are more stable and predictable.
Personality: Risk aversion refers to how comfortable you are with uncertainty and the potential for loss. Some investors naturally have a high tolerance for risk, while others are afraid of losing money, leading them to choose more conservative investments. Personal experiences, market knowledge, and emotions can be part of this factor as well.
Understanding the factors that influence your risk tolerance is the first step. Once you assess your risk tolerance and figure out where you’re at, you'll be more prepared to start your investment journey.
How to assess your risk tolerance
Figuring out your risk tolerance level lays out an important part of the framework for your investment strategy. Then you can make informed decisions that help you achieve your financial goals without adding stress to your life. Here are a few tips on how to evaluate your risk tolerance:
Use risk tolerance assessment tools: Various online tools help you assess your investment risk style. Use these tools as a starting point but don't rely solely on them for guidance!
Get in touch with your feelings: If red numbers in the stock market put you in a panic or compel you to sell early, you may have lower risk tolerance. Think about how you react to stressful situations, your personal relationship with money, and how you'd cope with the inevitable market swings.
Start slowly: Your risk tolerance isn’t static — it’ll change as you learn more about investing. Seasoned investors who have seen market trends come and go tend to have a higher tolerance for risk. As you gain more experience, your risk tolerance may evolve.
How much risk can you realistically take on without jeopardizing your lifestyle? Consider your current income, savings, debts, and upcoming financial needs. Also, think about how much fluctuation in your portfolio you can endure while staying confident in your long-term plan. And always be honest with yourself: How would you really react to financial losses?
Understanding risk tolerance levels
When it comes to risk tolerance, there are three main levels: conservative, moderate, and aggressive. The asset allocation within each risk tolerance category varies significantly, too.
Conservative investors prioritize preserving their capital. They usually aim for stability and favor lower-risk investments like bonds and cash equivalents. For example, their portfolios might consist of 70% bonds and cash equivalents and only 30% stocks.
Moderate investors try to balance risk and return. They’ll often choose a mix of stocks and bonds to achieve growth while managing volatility. Asset allocation for a moderate portfolio could be 60% stocks and 40% bonds.
Aggressive investors are willing to accept significant risk for the possibility of higher returns. They often invest heavily in stocks and alternative investments like cryptocurrencies. Aggressive portfolios often include 80% or more in stocks and alternative investments, with very little allocated to bonds.
Since your risk tolerance can change over time, it’s wise to rebalance your portfolio regularly. This way, you can make sure your investment choices still reflect the level of risk that you want to take.Ultimately, knowing your own risk tolerance allows you to make informed decisions about how to manage your portfolio and allocate assets. When the market swings back and forth — as it always does — you’ll be less stressed if your investment strategy matches your risk tolerance. And if you find it hard to navigate these adjustments on your own, it’s a good idea to seek professional financial advice.
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FAQs
Usually, your risk tolerance is highest when you're younger and have a long investment time horizon. Plus, when you have a stable income but relatively few financial responsibilities, you’re better positioned to ride out market fluctuations.
Risk tolerance is what you’re willing to put up with, while risk capacity is what you can survive financially without jeopardizing your security. Both are important for creating a balanced investment strategy, but they don't always match — someone may have high risk tolerance but low risk capacity, or vice versa.
Many investors shift toward a more conservative approach because of major life events, such as getting married, buying a home, or approaching retirement. Market conditions and personal investment experiences may also influence how much risk you're willing to take. Reassess your risk tolerance regularly to make sure your investment strategy still aligns with your current financial and long-term goals.
If you have low risk tolerance, you could for example focus on stable, conservative investments that offer steady returns but don’t have much volatility. Diversifying your portfolio across bonds, dividend-paying stocks, and cash equivalents can also help reduce risk while still providing some growth. And investing in index funds or ETFs gives you broad market exposure with less risk than individual stocks.
There are pros and cons to all investment strategies. With low-risk investments, the advantage is that you’re less likely to experience volatility and major losses. But the downside is that low-risk investments often result in lower returns compared to more aggressive investments like stocks. This can make it challenging to keep pace with inflation. Risk-averse investors might also miss out on chances for high growth.
Different types of investments are known to carry more or less risk. Once you figure out your risk tolerance, you can also consider your time horizon, financial goals, and budget. All these factors will help you determine how much money you can put into riskier investments like stocks, and how much you should keep in an easy-access savings account or invest in bonds. If needed, consult a financial advisor for personalized guidance.
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