Risk Tolerance in Investing: What It Is, Types, and How To Assess It
As you set out on your investing journey, you may come across the topic of risk tolerance. For complete financial newbies, the term can be a little confusing. What does it mean, why does it matters, and how can you assess your personal risk tolerance level?
In this article, we find out. Read on to learn more.
What Is Risk Tolerance In Investing?
The meaning of risk tolerance is quite easy to grasp. It is the acceptable volatility in returns that an investor is willing to accept when making an investment.
In general, there is a tradeoff between volatility and expected returns. The higher the expected returns on an asset, the more its price will fluctuate.
A Treasury Bill or T-bill return volatility in the US, for instance, is low. The owner receives a guaranteed sum of money after waiting a fixed amount of time.
By contrast, cryptocurrency returns are much more volatile. In some years, coins can rise by 2,000 percent, while in others, they crash by 95 percent.
Risk Tolerance Types
The type of securities that comprise a person’s portfolio determines their investment risk tolerance. Let’s say a young investor with a long future ahead of them puts $1,000 into a highly speculative digital startup. If the company succeeds, returns could be 10,000 percent or more. If it fails, they could get nothing.
Similarly, you could have an older investor who wants to preserve the wealth they already have for retirement. This individual is much more likely to buy bonds to protect their net worth since the value of these assets is less likely to fluctuate.
Analysts sometimes classify investors by putting them into categories based on the types of risk tolerance they are willing to accept.
Examples of risk tolerance include:
Conservative investors take the least amount of risk possible to preserve their capital. As such, they naturally gravitate to assets that make them feel safest. For them, avoiding losses is much more important than making gains. Many invest in savings accounts that pay guaranteed interest or government bonds.
A typical conservative investment portfolio might look something like this:
- 20 percent T-bills
- 60 percent certificates of deposit (CDs)
- 20 percent cash
Investors with moderate risk tolerance are more willing to take risks, but they still balance volatility with returns. Their portfolios comprise a combination of risky assets, such as stocks, and low-risk assets, such as bonds. They may also assess the risk level within a particular asset class, choosing value-oriented stocks over growth or government T-bills over commercial junk bonds.
A typical moderate portfolio might look something like this:
- Three percent cryptocurrencies
- 27 percent value stocks
- 10 percent growth stocks
- 10 percent gold
- 40 percent T-bills and other government securities
- 10 percent cash
Aggressive investors have a high-risk tolerance. They are less averse to losses and more willing to take bigger risks, as long as expected returns are higher. Psychologically, these investors understand the market’s ups and downs and are prepared for them when they happen. Investors tend to be wealthy, experienced, and have a broad portfolio they can play with.
An aggressive investor’s asset allocation might look something like this:
- 10 percent cryptocurrency
- 60 percent growth stocks
- Five percent gold
- 15 percent corporate bonds
- 10 percent cash
Aggressive investors tend to buy for the long-term and don’t panic sell, even if prices slump for several years. They tend to believe they will win in the long term.
How To Measure Your Risk Tolerance
Measuring your risk tolerance helps you make the right investment decisions. Ultimately, the goal is to settle on a portfolio allocation that supports your desired lifestyle.
Note that risk tolerance and risk capacity are not the same. You may have the ability to take on a high level of risk, given your personal financial situation, but that doesn’t mean you should.
For example, your ability to take on additional risk might be quite low if you have a mortgage, kids approaching college age, or a private business. By contrast, your willingness to take risks might be higher if you are single, live with your parents, and don’t own a car.
Assess Your Goals
When defining your risk tolerance, you need to assess your goals – what you want your wealth to achieve.
If you want to preserve your money for retirement, your risk tolerance will be low. You’re looking to protect what you’ve saved during your working life, not gain massive returns from which you may never benefit.
Likewise, you have more time to recover from a loss if you have a longer horizon. Twenty-year-olds can easily ride out a ten-year stock bear market and then benefit from outsized returns in their thirties.
The exception is building intergenerational wealth. Here, the time horizon is essentially infinite, so consistent long-term returns matter more.
Suppose you have multiple goals; that makes decision-making a little trickier. One strategy is to divide your portfolio into weighted buckets and then allocate funds according to the importance you assign each objective. Another is to meet goals sequentially in priority order, assigning assets to new portfolios once older ones achieve their goals.
Translate Goals Into Investment Strategy
Once you know your goals, the next step is to translate them into an investment strategy. The task is to allocate your portfolio between different assets, depending on the level of risk you are willing to accept.
There are three ways of doing this:
- Doing it yourself
- Speaking to a broker, financial adviser, or investment manager
- Using a robo-advisor
You’ll also want to think carefully about how you are likely to react emotionally to a moderate investment loss. If you are a person prone to panic, you may be better off choosing a lower-risk portfolio skewed towards bonds, even if you have aggressive wealth-building aspirations. By contrast, if you can cope with losses or even see them as opportunities, you might be a good candidate for an aggressive portfolio.
Lastly, you’ll want to consider when you need the money. Aggressive portfolios tend to perform well over the long term, but they can hop up and down wildly in the interim, making them an unstable source of liquidity, for instance, if you want to buy a house.
Knowing your risk tolerance helps you make better portfolio allocation decisions. By choosing the right mix of assets for you, you can achieve your goals faster, whatever they happen to be.
How do you measure risk tolerance?
The standard approach for measuring risk tolerance is to ask investors a series of questions about the losses they are willing to incur. You can also measure risk tolerance by exploring the factors that determine how risk-loving or averse a person is likely to be, such as their age, when they need the money, and how they would react emotionally if their portfolio lost money.
What are the types of risk tolerance?
Analysts and financial commentators typically classify investors into three risk tolerance categories: conservative, moderate, and aggressive. Conservative investors prefer guaranteed returns and loss avoidance over the prospect of higher returns, while aggressive investors are the opposite. Moderate investors take the middle ground.
What is the importance of risk tolerance?
Learning about your risk tolerance makes constructing a portfolio that fulfills your long-term financial objectives easier. The objectives can be retiring by a certain age or gaining financial independence. Too much risk could mean that cash is not available when you need it, while too little risk could reduce the value of investing long-term.
I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.
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