Determining Your Risk Tolerance - A Comprehensive Guide

Risk tolerance varies from person to person. Some people have no fear of parachuting out of an airline, while others won’t even ride a rollercoaster at a theme park. Everyone is a combination of their own ideas and experiences, which is why topics like risk tolerance are constantly evolving. Risk can’t be avoided entirely in investments, but the amount of risk we’re exposed to can be modified by concentrating on a few key factors.

Before you invest, it's essential to understand your risk tolerance. While no one-size-fits-all investment plan exists, specific forces consistently influence our decisions. In this article, we’ll guide you through measuring your personal risk tolerance, explain the factors involved and help you identify the right assets for your risk tolerance level. 

What Are the Different Types of Risk Tolerance?

All investments carry some risk. Even safe assets, like bonds, index funds or your primary residence, can lose value. Risk tolerance measures how much price volatility you’re willing to withstand on your asset to maximize returns. 

Risk-taking can be rewarded, but risky assets can also suffer prolonged drawdowns. Like Goldilocks, you’ll want to adjust the temperature of your portfolio until your asset allocation is just right. Here’s a rudimentary example of 3 different levels of risk tolerance.

Aggressive Risk Tolerance

For those with an aggressive investment risk tolerance, the thrill of high-volatility assets is part of the game. Aggressive portfolios often feature stocks from dynamic sectors like tech or consumer discretionary, and certain market conditions can lead to significant returns. Investors with long time horizons often opt for aggressive portfolios as they can best weather extended drawdowns.

Moderate Risk Tolerance

Moderate investors try to balance their portfolios with risk assets and income-producing instruments. An excellent example is the classic 60/40 portfolio, where an investor puts 60% of the capital into stocks and 40% into bonds.

Conservative Risk Tolerance

Sometimes, preservation is more important than accumulation. Conservative investors often prefer consistency to market-beating returns, so they prefer bank CDs, bonds or dividend-paying stocks. Retirees usually have conservative investment plans to earn steady income-based returns while spending down their nest egg.

How to Determine Your Risk Tolerance

Risk tolerance is a matter of personal preference. Time horizon plays a considerable role but is far from the only important factor. Two investors with similar timeframes may still have drastically different risk tolerance levels depending on their family situation, career or health. You’ll want to consult with an advisor to develop personal risk tolerance guidelines, but here are a few considerations to take into the meeting.

Consider Current Investments and Goals

Why are you investing in the first place? Is it to build a nest egg for retirement or a child’s education, or to save for a house down payment or exotic vacation? Your goals will significantly influence the level of risk you apply to your portfolio. For example, a vacation isn’t necessary, so you might be more comfortable taking risks in that scenario than if you were saving for something more essential like a house or college tuition.

Consider Your Age and Time Horizon

Market timing is tricky, but the time you spend in the market is within your control. If you’re a young investor climbing the career ladder, you have 2 huge advantages: time and physical capital. You have decades to earn income and invest that income aggressively. 

According to concepts like time diversification, investing in stocks over long timelines is less risky since the portfolio can be adjusted as the timeframe winds down. Investors in securities like target-date funds have their level of risk automatically toned down as their expected retirement date approaches. Older investors may not be able to afford a risky process since they no longer earn income through their jobs and depend on their investments for living expenses.

Consider Your Personal Comfort Level

Separating emotions from investing is complicated. Can you tolerate an extended drawdown? Are you afraid of pulling money out of risky investments at the worst possible time? Be honest with yourself when considering this factor. Only some investors can tolerate watching their portfolio drop 10-20% quickly, which is often how bear markets materialize. If the idea of losing a big chunk of your capital makes your stomach churn, you might prefer a conservative portfolio, even if you have a long time horizon.

Adjusting Risk Tolerance Over Time

Risk tolerance isn’t fixed; it’s a malleable trait that changes based on personal situations and timelines. This adaptability provides reassurance and flexibility in your investment journey. Age is a good barometer of risk tolerance; younger investors will naturally be able to tolerate more risk than older ones.

However, risk tolerance also changes with income, family dynamics, health and economic environment. An investor with a spouse and 3 children probably won’t have the same comfort with risk as someone the same age with no dependents. Life constantly changes, and keeping up with market headlines can be difficult. Always take time to chat with an advisor if your scenario changes.

Conclusion

Risk tolerance is a tool to determine what assets are ideal for a specific investor’s portfolio. Understanding risk tolerance allows you to construct a portfolio that aligns with your financial goals and comfort levels, making you feel secure and prepared. Aggressive investors with long time horizons can invest in riskier asset classes like individual stocks, while risk-averse investors may prefer bonds or index funds. Several factors go into the risk tolerance equation, such as timeframes, family situations and personal comfort levels. Consider an advisor's services when deciding to change the makeup of your portfolio.

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Source MarketBeat