What is risk tolerance and why is it important?

Definition of risk tolerance

Risk tolerance is your ability and willingness to withstand a decline in the value of your investments. When trying to determine your tolerance for risk, consider how comfortable you will feel to hold your positions when the stock market is experiencing steep declines.

There is an old Wall Street adage that goes, “You can eat well or sleep well. Eating well refers to the observation that over the long term, holding higher risk assets (such as stocks) allows investors to accumulate significant wealth. However, this comes at a price, as stocks can be quite volatile, causing investors to lose sleep.

Why risk tolerance is so important

Your risk tolerance plays a crucial role in your game plan to grow your money without worrying about it on a daily basis.

If you do not have the courage to face the risks of losing your capital, even temporarily, you will have to settle for less risky investments and the lower returns that come with them. Investments with the potential for higher returns often come with a higher potential from sudden downdrafts or outright loss.

With an understanding of your risk tolerance, you can create a strategy for your investments that will help you balance volatility concerns with the potential for larger returns when you look at the big picture.

How risk tolerance works

Anyone can have a high tolerance for risk when stocks are up. However, the best time to really assess your tolerance for risk is when the market is going down.

Think about March 2020. The market has collapsed. Unemployment figures have skyrocketed. The world has faced an unprecedented level of uncertainty, wondering if COVID-19 would destroy the economy.

What was your risk tolerance then? Did you withstand these difficult times? If you were to sell stocks in the midst of the panic, your tolerance for risk was low. Or were you prepared to invest more to take advantage of the market selloff? If so, you had a high tolerance for risk and it served you well as the stock market set record numbers.

Types of risk tolerance

There are different types of risk tolerance.

Conservative risk tolerance

With this mindset, an investor focuses on preserving capital and avoiding downside risk. This means lower returns, but the investor will be content with this in exchange for avoiding any wild changes in value. For example, a certificate of deposit is a very conservative investment. A bank or credit union will guarantee a certain rate of return in return for keeping an investor’s money under lock and key for a predetermined period. The promise of return is a pro, but the low earning potential (CDs historically pay much less rate of return than stocks and real estate) can be a downside. An older investor approaching retirement will likely have a fairly conservative tolerance for risk.

Moderate risk tolerance

Moderate risk tolerance keeps one foot in two camps: conservative and aggressive. A classic example includes the traditional 60/40 split between actions and obligations. This balances some of the money invested for growth (stocks) while maintaining an eye on stability for income generation (bonds) at the same time.

Aggressive risk tolerance

With an aggressive risk tolerance, the majority of an investor’s portfolio is allocated to riskier assets such as stocks and real estate. These offer the prospect of higher returns over time. This component of time is a key ingredient, however. The investment has a greater chance of losing value in the meantime, and there is no guarantee that an investor will actually get the money back. Being aggressive means being prepared to accept the chance of losing some or all of the capital.

How to determine your risk tolerance

To determine your risk tolerance, you need to answer a few key questions:

  • What are your investment goals? Do you invest regularly and seek to increase the value of your nest egg? Or do you already have a decent nest egg and rather than growing it, are you looking to preserve it and live off the income it generates? Each will convey a different tolerance for the risk of falling prices.
  • When do you need the money? Your time horizon is a crucial part of the equation. The sooner you need money, the lower your tolerance for risk should be. The money you need for a down payment for a home next year has an entirely different time horizon than the money you accumulate for retirement that is still years away.
  • How would you react if your portfolio lost 20% this year? Assessing your tolerance for risk involves thinking about what-if challenges and worst-case scenarios. If your investment lost 20% of its value, would you lose sleep at night and withdraw all your funds? Or would you leave it invested and consider putting even more money into the market to take advantage of the discount?

How the investment experience relates to risk tolerance

What is your level of investment experience? When determining the level of risk you can handle, it’s also important to think about your level of knowledge of the investment landscape. It has never been easier for anyone to open an online brokerage account and select stocks and other investments, but this level of convenience can also be quite expensive.

Online chatter can create momentum around stocks and other investments that fuel the uninformed buying and selling of inexperienced investors, making them vulnerable to large losses. So be honest with yourself about your level of expertise. And when you start to invest your money, be sure to invest your time in expanding your financial literacy.

Risk tolerance vs risk capacity

It is important to assess your risk tolerance against your ability to take risks. These two components must be aligned.

For example, if you are in your 20s and saving for retirement in your 401 (k) workplace, you have a great risk capacity. You can be 45 or 50 years old before retirement, which means you can afford to invest aggressively with the ability to resist the potential for downside. However, your risk tolerance may not match this. You might be a nervous investor.

Think about the risk as a whole

When you are at the start of your career and start investing, it is important to have a long-term vision. It can be difficult to watch your investments go down overnight. However, if you don’t invest that money for tomorrow or next month, you have to recognize that it’s the end of the game that really matters.

The stock market may achieve an average annual return of 10% over time, but it does not generate those 10% gains every year. Some years it can go down by more than 30 percent, while in others it can go up by more than 30 percent. Measure how your yields grow over time, not every day. As you get closer retirement, this is when you will need to examine your ability to deal with downside risk. Be sure to reassess your risk tolerance and your ability to take risks to make the necessary adjustments.

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