What Is Risk Tolerance Why Is It Important?

Have you ever had the urge to ride the tallest rollercoaster in the park? If so, then you may have a high tolerance for risk. While riding the highest rollercoaster might not seem like a risky endeavor, it still comes with a level of anxiousness you won’t find on the kiddie rides.

Figuring out your investment risk tolerance is like figuring out how high a rollercoaster you’re comfortable riding. Some investors can tolerate massive peaks and valleys of volatility, while others prefer the market equivalent of the Merry-Go-Round. Risk tolerance is crucial because it helps develop a thorough financial strategy and prevents irrational decision-making.

The Difference Between Risk Tolerance and Risk Capacity

Tolerance and capacity are related ideas, but they describe 2 different types of responses to risk. Both need to be considered in a financial plan, so it's important to understand the nuance between the 2 concepts.

Risk tolerance measures our comfort level when putting money into markets. How does a loss make you feel? If you’re an emotional investor, you might have a low-risk tolerance since losing money could induce poor decisions. Conversely, your risk tolerance might be high if you have a calm hand during market volatility since significant losses won’t send you running for the exits.

Risk capacity measures how much capital an investor can realistically put into assets like stocks. It's not your personality at play here but your financial situation: your income, career, debt obligations and family. A single investor with a promising career has a higher capacity for risk than one with a family or a career in transition. 

An investor with a low-risk capacity may still have a high-risk tolerance. For example, if you fear layoffs are coming at your company, you might cut back on investing and focus on savings, even if your heart rate is usually unaffected by losses.  

How to Assess Your Risk Tolerance

What factors go into a risk tolerance assessment? Risk tolerance is a matter of personal preference. Investors with similar timelines and capital may still have wildly different views on risk depending on their personalities or life circumstances. Figuring out your risk tolerance requires some self-testing, so ask yourself the following questions:

• What are my objectives and timeline as an investor? If you’re saving for a retirement that’s still decades away, you’ll probably view risk differently than someone with a family saving for a house down payment.
• What is my current income status? If you’re a high earner and max out all your tax-deferred retirement vehicles, you probably have more capital for higher-risk investments than someone who just contributes to a 401(k).
• What is my life and family situation? As we get older, life tends to force risk tolerance adjustments. A wedding, vacation, children and the future education of those children are all significant emotional and financial events that require a personal risk re-evaluation.

MarketBeat has plenty of tools to help you start your personal risk assessment. But remember, it's crucial to be honest with yourself. Be realistic about your goals and mindset, and always consult an advisor before making big decisions.

How Risk Tolerance Influences Investment Choices

Risk tolerance looms large over the makeup of our portfolios. Investors with little appetite for risk have a portfolio composition that is much different from those who can stomach wild stock market volatility. Here are 3 basic risk tolerance examples:

Low-Risk Tolerance Investment Strategies

Investors with a conservative risk tolerance are more interested in wealth preservation than profit accumulation. Low-risk tolerance strategies are often used by retirees or older investors who prefer consistency to outperformance.

A portfolio of low-risk assets can include government or corporate bonds, dividend-paying stocks or funds in low-volatility sectors like utilities, annuities, money-market funds or FDIC-insured instruments like certificates of deposit (CDs) or high-yield savings. For most conservative investors, the key is to minimize volatility while producing steady (if unspectacular) income.

Medium-Risk Tolerance Investment Strategies

Investors can find a middle ground between high- and low-risk strategies by dividing their capital between income-producing assets and higher-volatility investments. Medium-risk tolerance investors often split their assets into two buckets: one for short-term needs and one for long-term needs. The short-term portfolio would consist of CDs, bonds or dividend-paying stocks, while the long-term portfolio is filled with growth assets like tech and consumer discretionary stocks.

The classic 60/40 stock-bond portfolio is an excellent example of a mid-range risk strategy. Investors still have more capital in stocks than bonds, which limits the upside during bull market runs. However, during market drawdowns, the bond portion should act as a buoy, keeping the portfolio afloat until the turbulence subsides.

High-Risk Tolerance Investment Strategies

Investors with high-risk tolerances typically devote most of their portfolios to stocks or derivative instruments. Volatility isn’t a bother for someone with a high risk tolerance since they often have the timeline or capital capacity to withstand drawdowns, economic trouble or earnings misses. If 60/40 is the model portfolio for medium risk tolerance, a high-risk investor will have 90% (or more) of their money in stocks.

High-risk investing doesn’t mean reckless, however. On a long timeline, stocks tend to beat other asset classes. Since 1971, average annual returns from the S 500 are estimated to be between 7% and 10%, depending on whether you reinvest dividends. If your timeline measures in decades, allowing risky stocks to compound can produce a substantial nest egg - just make sure you have the emotional strength to withstand bear markets.

Adjusting Risk Tolerance Over Time

Risk tolerance isn’t something you set and forget like your morning alarm clock. It morphs and evolves as your life reaches different stages. When you start your career, you have time and future earnings on your side. But as retirement approaches, timelines compress, and your expected future income can no longer be a buffer to market volatility.

Retirement is just one of many life changes that force a risk tolerance adjustment. Perhaps you marry a spouse with a lower risk appetite or pivot to a new job with a different salary. As life changes, so will your risk tolerance. Consider reviewing your investment plans every so often to ensure your risk tolerance still matches your goals and position in life. 

Keep Learning with MarketBeat

Risk tolerance can be complicated since every investor has different objectives and timeframes. MarketBeat has risk tolerance assessment tools to help you start your journey. Click here to learn more about our products and offerings.

Source MarketBeat