What Is Risk Tolerance?
Risk tolerance is the amount of portfolio volatility an investor is willing to tolerate as part of an overall financial plan. As a key ingredient to investing, understanding risk tolerance will help an investor create an asset allocation for the investment portfolio that helps reach their financial goals, without losing (too much) sleep over the ups and downs of the market.
Risk tolerance is determined by two factors:
the ability to take risk and
the willingness to take risk
The ability to take risk depends on objective factors, such as the investor's age, wealth, and investment time-horizon. For example, younger investors should have more time available to invest, thereby allowing them to take on more risk. The willingness to take risk is a behavioral trait that varies with the investor’s personality and experience.
Risk tolerance is critical when constructing an investment portfolio and choosing asset classes. It is the basis of determining the asset allocation in many investment products, such as “life cycle” portfolios used in many retirement accounts or in robo-advising.
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So, risk tolerance is an important factor to consider when working with a financial planner, or planning for your own financial goals. Understanding how much market risk you can tolerate will help you put together an investment strategy you can live with. Keep in mind that risk tolerance will change over time, as you age and gain experience, your investment goals change, and, typically, your net worth increases. It is important to adjust your plans–and your portfolio–as that happens.
Common Risk Tolerance Categories
There are typically three different risk tolerance categories that investors are associated with, each with varying degrees of risk.
Aggressive Risk Tolerance
An aggressive risk tolerance is characterized by the ability to handle large investment losses without worrying about the overall outcome of a financial plan. An aggressive investor is typically younger, or has a higher net worth, and may have a higher risk capacity, taking on more risk for higher potential upside.
This typically includes investing a higher percentage of one's portfolio into higher risk assets like equities (such as stock index funds), or other high-risk investments such as single stock or cryptocurrency. An aggressive asset allocation typically has 70% (or more) of the investment portfolio allocated to higher-risk investments.
Moderate Risk Tolerance
Having a moderate risk tolerance means having a more balanced investment strategy, taking on less risk by allocating more money to bonds or other fixed-income securities. A typical moderate portfolio is known as the 50/50 portfolio, whereas 50% of the portfolio is made up of equities, and the other 50% is made up of fixed-income and low-risk investments (such as Treasury Notes). Those with moderate risk tolerance tend to be a little older (think, 45 years old or older), or have a shorter investing time horizon (fewer than 10 years).
Conservative Risk Tolerance
A conservative investor will often have a very low risk tolerance, and will build an investment portfolio that holds a majority of its assets in fixed-income securities (such as bonds), or in other risk-free assets. A conservative investment portfolio may look like a 40/60 or even 20/80 portfolio, consisting of 20% - 40% equities, and 60% - 80% fixed-income (such as bonds). Conservative investors want to avoid major portfolio drawdowns, giving up the upside of equity investing for the stability of low-risk investments.
Risk Tolerance Questionnaire
How much risk are you comfortable with? A risk tolerance questionnaire is standard now for working with any investment advisor, robo-adviser, or brokerage. Our brief example of a risk tolerance questionnaire shows you how quizzes work to help you define your risk tolerance.
Which investment portfolio do you prefer?
Low Risk/Return. Average annual growth of 2% - 3% per year, but may lose 2% - 5% in a given year.
Moderate Risk/Return. Average annual growth of 4% - 5% per year, but may lose 10% (or more) in a given year.
High Risk/Return. Average annual growth of 6% - 7% per year, but may lose 20% (or more) in a given year.
Highest Risk/Return. Average annual growth of 8% - 9% per year, but may lose 30% (or more) in a given year.
If you had $100,000 invested, what is the most it could drop in a single year before you would want to change your portfolio?
I don't want it to drop at all (0%)
If the market goes down, I would want to move my riskier investments into safer investments.
I somewhat agree
Do you agree with this statement? "I prefer very little fluctuation in my investments, even if it provides lower overall returns."
I somewhat agree
How likely are you to stick to a long-term investment time horizon for your investing plan (15+ years)?
Select the statement that most resembles your feelings on investment risk.
It is more important for my investments to have very few declines in value than it is to earn higher long-term returns.
It is more important to hit my investing goals, even if it includes high volatility within my portfolio along the way.
How important is it that you hit your investing goals?
Not that important. I would like to achieve my investing goals, but if I don't, I have other means of affording my goals (family support, inheritance, employment income, etc.).
Very important. It is very important that I hit my investing goals, and am committed to consistently investing toward them.
How often do you plan on contributing toward your investments?
Frequently. I plan on contributing at least once a month toward my investment accounts.
Infrequently. I will contribute to my investment accounts when I can, which may only be once or twice a year.
Rarely. I will rarely invest, and only when I have extra funds available.
Risk Tolerance Results
These quizzes usually have a scoring system that allows you to interpret the results as:
Conservative. You don’t enjoy volatility in your portfolio, and prioritize preserving your investments over high returns. A portfolio mix of 40/60 or even 20/80 would fit your risk profile. If you answered No. 1 to most of the questions above, you’d likely fall into this category.
Moderate. You want to grow your investments, but also prefer less market volatility. A portfolio of 50/50 or maybe even 60/40 would fit your risk profile. If you find yourself in the middle of the conservative and aggressive answers, you’d likely fall into this category.
Aggressive. You are younger, or have a high tolerance for large swings in the value of your investments. You don’t mind a riskier approach to earning higher returns. An 80/20, or perhaps a 90/10 portfolio, would be appropriate for your risk profile. If you answered No. 3 or No. 4 to most of the questions above, you’d likely fall into this category.
Risk Appetite vs Risk Tolerance
While risk tolerance refers to an investor's willingness to accept variance within an investment portfolio (particularly to the downside), risk appetite is the amount of risk an investor is willing to take on to achieve their financial goals. You can have a low risk appetite, but still have a high risk tolerance (and vice versa), depending on your overall goals.
For example, if you are investing toward retirement, you may choose to invest in a high percentage of equities, showing a high risk tolerance. But since your risk appetite is low, you choose a broad-based index fund (such as Vanguard's Total Stock Market Index Fund) instead of picking individual stocks.
Investment Risk Tolerance
While an investment portfolio and its asset classes are constructed with risk tolerance in mind, selecting individual investments should also consider the level of risk before investing in them. For example, when picking out the fixed-income investments for your portfolio, if you have a higher risk capacity, you may choose to invest in short-term corporate bonds instead of inflation-protected treasury notes (TIPS).
Investment risk can also include spreading your investments across multiple asset classes, lowering the overall risk of an investment portfolio.
Why Does Risk Tolerance Matter?
Defining your risk tolerance is a crucial part of building an investment plan that you can stick with. If your investment plan goes beyond the maximum risk you are comfortable with, you may abandon it when there is a severe market downturn. If it is too conservative, you may not realize the return you are hoping for to hit your financial goals, such as retirement. When you are an aggressive or conservative investor, risk tolerance is an important consideration for any investor and their financial planning process.
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