There are always different levels of risk in life. It’s all about how much you’re willing to take and whether the rewards outweigh the risks.
When it comes to investing, you may be faced with a similar question: What’s your comfort level when it comes to the possibility of losing money?
This is referred to as your investment risk tolerance. Understanding what risk tolerance is, how it works and what factors affect your own risk tolerance can make you a better investor and help you build a stronger financial future.
What Is Risk Tolerance?
Risk tolerance is a measure of how much you’re willing to risk when you invest your money. The higher the risk, the greater the potential for a higher return on your investment. But there’s also a greater chance of losing your investment.
Why Risk Tolerance Is Important and How It Works
Risk tolerance is important because it affects both your long-term financial goals and how you choose to invest your money.
A high risk tolerance offers the potential for big returns, but it may also steer you toward riskier investments that can lose value quickly. A higher risk tolerance also means you need to monitor your investments or pay a premium to have a money manager to do it for you.
A low risk tolerance can help you avoid losing money, but it can also be a constraint if it keeps you from reaching your investment goals.
For most investors, a moderate risk tolerance provides a balance between these extremes. However, what seems like a moderate-risk investment one year could wind up being a low- or high-risk investment later.
Risk tolerance vs. risk capacity
There’s an important distinction between risk tolerance and risk capacity. Risk capacity is measured by weighing how much you can realistically afford to contribute to your investments and risk losing.
For example, let’s say you went to a casino and bet $50,000 on a single hand of blackjack. Win or lose, you have the same aggressive risk tolerance and could win the same amount of money.
However, if you have more money that you’re realistically able to risk, your risk capacity is higher.
For example, if that $50,000 was the difference between buying a Bentley or a Lexus, your risk capacity is higher than someone who just bet their entire life’s savings.
Three Categories of Risk Tolerance
Risk tolerance is usually divided into three categories: aggressive, moderate and conservative. Each risk tolerance level determines how much of your portfolio is invested in high-, medium- and low-risk investments.
There are many ways to invest your money, including individual stocks, stock funds, real estate, commodities (like gold), annuities and even cryptocurrency. However, most investment advisors discuss assets in terms of three key asset classes: stocks, bonds and cash.
- Stocks: Also referred to as equities, these are investments in the stock market, either in individual stocks or stock funds. Historically speaking, these investments offer an annual rate of return ranging from 7% – 10% on average.
- Bonds: These are investments in government-backed securities like U.S. Treasury Bonds, savings bonds and mortgage bonds. They’re usually a safer investment but tend to only provide an annual return ranging from 3% – 4% on average.
- Cash: The safest form of investment, you put your money into a Federal Deposit Insurance Corporation (FDIC) or National Credit Union Association (NCUA) insured savings or money market account. You’ll probably earn less than 1% annually, but you won’t lose money no matter what the market does.
How To Determine Your Risk Tolerance
Your risk tolerance should be based on the amount of time you have to invest, your goals and your financial situation.
You’ll want to ask yourself these questions when considering your risk tolerance level:
Where are you in your earning life?
How you earn income may affect your risk tolerance. Let’s say you’re in a career with lower income at the start but opportunities for more income later. You may want to adjust your investment strategy to keep your risk to a minimum now and wait to make riskier investments until you have more income to spare.
On the other hand, say you’re earning 6 or 7 figures in your 20s, but you’re working in a career with limited longevity. You may want to invest aggressively in the short-term, while you’re earning the big money, and get more conservative later on.
What is your time frame?
If you’re looking to save for long-term goals, like retirement, you may want to start with a more aggressive strategy. Understand that you have a long time horizon to achieve long-term gains and can shift to a more moderate strategy over time.
Conversely, if you’re closer to retirement age, you may want to shift to a more conservative strategy. That way you’re less likely to lose money if there’s a market downturn.
What are your goals?
The traditional model for retirement suggests you gear your investment risk strategy so you can enjoy life to the fullest when you turn 65 or 70. However, some people are embracing the Financial Independence, Retire Early (FIRE) movement. This involves saving and investing aggressively in your 20s and 30s with the goal of funding a lower-cost retirement plan that lasts longer.
What are your responsibilities?
If you’re single, you may be more willing to take risks than if you have a family to care for. If you invest aggressively, there’s a greater risk the money your family needs won’t be there later on. On the other hand, investing too conservatively may also limit your ability to take care of your family later.
How Risk Tolerance Affects Investing
When you take all of these factors into consideration, it can help you determine what level of risk tolerance is right for you. Consider these 3 scenarios based on the different levels of risk tolerance.
You’re in your mid-20s. You’re making a six-figure salary and have no student debt. You work long hours and don’t have time for a social life. You want to buy a home and start a family when you turn 35 and aim to double your money in 10 years.
You pursue an aggressive investment strategy and in the first 3 years, the market is climbing, your investments are booming and your money grows by 50%. But market volatility goes both ways. In year 4, there’s a stock market drop. Suddenly your investments lose most of their value.
You find you’re right back where you started. But you’re sure the market will turn around and still have five more years to reach your goal.
You’re a recent law school grad and have joined a law firm as an associate at $90,000 a year. You have a lot of student loan debt, but you know you’ll earn big money when you make partner.
Meanwhile, you make the maximum contribution to your firm’s 401(k). You also put whatever money you can spare into a mutual fund with a balance of stocks and bonds that normally earns around 6% a year. You’re building an investment portfolio slowly. While some years are better than others, you’ll probably have enough to live comfortably when you retire in 30 years.
You’ve been working for a Fortune 500 company for the past 25 years. You’ve built a solid career for yourself but feel like you’re ready for a change and decide to start your own business.
You know starting a business can be risky, especially in the first few years. You have an emergency fund but decide to shift your portfolio from stocks into bonds, cash and other low-risk investments. That way you know your money will be available if you need to dip into your investments.
Turning in Your Cards Early May Stunt Your World Domination
Investing in your future is always a smart move. But decisions about how to make those investments shouldn’t be made lightly. Working with a reputable investment professional can help you invest in a way that matches your risk tolerance to your goals and timeline.