Why risk tolerance is so important to your financial goals
Risk tolerance is one of the most important — if not The most important — Considerations when constructing an investment portfolio or comprehensive financial plan. Risk tolerance is an investor’s ability to manage the variability of portfolio returns, and in practice it presents itself as the ability and willingness to take investment risks.
Generally, older investors have a lower tolerance for risk. Young investors can generally accept more risk, given their longer time horizons. However, this is by no means an absolute rule. Everyone’s risk tolerance should be assessed individually.
Defined risk tolerance
Risk tolerance is your ability to manage portfolio volatility. In this context, he is more concerned with large negative moves since people are able to handle positive returns quite well.
Risk tolerance can be influenced by a number of factors, including goals, age, degree of portfolio dependence, personal comfort, and absolute net worth.
People who save for an important goal, like retirement or college, are likely to have a higher risk tolerance the further they get away from that particular goal. This is because investment returns tend to be reliably positive over long periods of time, whereas they can be erratic and unpredictable in the short term. If the general market corrects or enters a bear market, long-term savers know they have a lead before their target deadline to avoid panic selling.
On the other hand, people facing a short period of time to prepare for their stated goal, such as a down payment on a house or paying off a high-interest loan, will likely have a much lower tolerance for risk. In these cases, staying completely out of the market might be the right move, as market fluctuations can be unpredictable. They’re especially nasty if you’re counting on the market to make a big outlay.
On average, young investors have a higher risk tolerance than older investors. Young investors have many years of hard work to earn, save, and invest money, while pre-retirees and retirees may need their wallets for day-to-day spending. As a result, younger investors have a much higher ability to tolerate large negative portfolio swings. Older investors can be badly hit by downside market shocks, making financial planning essential if you’re living on investments.
While age is generally inversely related to risk tolerance, it is not still the case. Sometimes retirees stop working with fully funded pension plans, social security benefits, and a strong personal savings account. These individuals may be able to tolerate more risk in their investment portfolios.
People who rely on their investments for living expenses will have a lower tolerance for risk than those who simply invest for many decades. The reason is simple: if you exit your growth assets when the market has fallen 20%, you are hampering your portfolio’s ability to grow by selling stocks at a discount.
If you live off your investments, consider setting aside at least a few years of cash living expenses to avoid having to sell later at an inopportune time.
Most investors simply don’t – and understandably – like to see their portfolio value drop in the midst of a stock market downturn. If you’re someone who doesn’t want to see your balance go down, even if it means losing the potential for more in the long run, you might have a lower than average tolerance for risk. Although volatility is an integral part of investing, it is entirely up to you to decide how much risk you are comfortable taking.
Absolute net worth
It’s possible that as your net worth increases, regardless of your age, your willingness to take additional risks with your money decreases.
For example, imagine you win a lottery jackpot in your thirties. In theory, you could keep trying to grow the money until you retire, but you could choose to keep it instead. Although your age indicates a high risk tolerance, your circumstances may cause your risk tolerance to be lower than it would otherwise be.
Types of risk tolerance
While there are gray areas within and between risk tolerance categories, the main ones break down as follows:
Individuals with a lower than average tolerance for investment risk. Typically, these investors will opt for an asset allocation with higher shares of cash, money market funds, CDs, some fixed income securities and real assets.
People with an intermediate view of investment risk. These investors can opt for equal or nearly equal shares of riskier and safer assets. For example, someone with a moderate tolerance for risk might have an asset allocation of 50% common stocks, 40% fixed income and 10% cash.
People willing and able to tolerate higher levels of risk. Usually, these investors have high portfolio concentrations of stocks and other volatile assets, potentially including speculative assets such as cryptocurrency or NFTs. These investors tend to be the youngest of the investor population, but this is by no means a rule.
Find your risk tolerance
Consider the following questions to help you determine your risk tolerance:
- What is your investment time horizon?
- Would others describe you as a risk taker?
- What is your general attitude towards the prospect of losing money?
- What is your current net worth and what is the marginal value of the dollar to you?
- Do you currently have multiple streams of income?
- Do you rely solely on your investments to cover your daily expenses?
- What are your short and long term investment goals?
- What is your investment experience?
- If the price of an asset fell dramatically, would you buy more of it, sell the position, or hold it?
- If an asset could lose 50% or gain 50% in five years, would you invest?
Risk tolerance vs risk capacity
Risk tolerance speaks of an investor’s attitude towards investment risk, combining both their ability and willingness to absorb negative changes in the value of their portfolio. Your risk tolerance tends to be qualitative in nature as there is a fair amount of emotion involved in investing.
On the other hand, risk capacity refers to your ability to bear financial risk from a purely quantitative perspective. In other words, depending on your life stage, you may only be able to afford a certain level of investment risk. If you take too much investment risk as a pre-retiree, for example, you might not be able to cover your expenses if the market were to fall for an extended period.
Risk capacity can also be defined as the amount of risk required before your ability to achieve set goals is affected. If your goal is to retire with a $1 million investment portfolio, but you hold all your saved money in cash, it will be difficult, if not impossible, to reach your goal without adding stock market risk. In this example, you need to determine a minimum acceptable level of risk that will still allow you to reach your goal of one million dollars.
It’s entirely possible that your risk tolerance doesn’t match your risk capacity, and that’s completely okay. Reducing your risk to levels you are comfortable with is part of learning about investing and a sign of maturity. There’s no shame in knowing when you’ve had enough, even if it means potentially lower net worth in the long run.
Related investment topics
Risk tolerance is key to sound investing
Remember that risk tolerance is a moving target and most investors struggle to set it all the time. As you develop the right risk tolerance, remember that this is a completely individual concept. You will need to consider all the factors that influence your portfolio — taken as a whole — to determine the appropriate level of risk for you.
As you build your financial plan, keep risk in mind for a smoother experience. Finally, be sure to integrate all the financial resources and not financial circumstances that may affect you in the future.
The Motley Fool has a disclosure policy.