What is Risk Tolerance in Investing? Why It Matters

When you invest, you expose yourself to risk - primarily the risk of losing money. Risk tolerance is a measure of how much risk you are willing to expose yourself to as you invest. When you invest, you are trying to balance the amount of risk you can manage with the pursuit of positive returns from your investments.

Think of risk tolerance as your emotional response to the fluctuating values of investments. For example, say that you decide to invest in a mix of stocks. At times, the stock market goes up, stays stagnant, or goes down. If the idea of watching the value of your stocks go down makes you sick to your stomach, you have a lower risk tolerance.

If you are okay stomaching the inevitable ups and downs of the stock market, you have a higher risk tolerance. Understanding your individual risk tolerance is important as it will determine what you should invest in.

Conservative Risk Tolerance - If you have a conservative risk tolerance, your primary goal is to preserve your money. You are not willing to take on much risk, if any at all. Your primary focus is to hold investments that are stable and do not have lots of volatility.

Moderately Conservative Risk Tolerance - If you have a moderately conservative risk tolerance, you are willing to risk a small amount of money for the potential of higher returns. You might allocate a small amount of your money towards higher risk investments, while keeping most of your money in lower risk investments. ‍

Moderate risk tolerance - If you have a moderate risk tolerance, you are willing to balance risk with reward. Half of your money might go toward higher risk investments that may provide higher returns, and the other half of your money towards conservative investments to preserve your portfolio.

Moderately Aggressive Risk Tolerance - If you have a moderately aggressive risk tolerance, you are willing to risk a majority of your money for higher returns. You might allocate 80% of your investments towards higher risk investments and the remaining 20% towards lower risk investments.

Aggressive Risk Tolerance - If you have an aggressive risk tolerance, your sole focus is to grow the value of your portfolio. You might allocate all of your money towards higher risk investments in order to increase the chances that your money will grow.

Higher risk investments are investments that are subject to higher levels of volatility. Volatility is simply how much and how frequently an investment's price changes over time. The more volatility an investment has, the greater the risk.

For example, a stock is subject to volatility. The price of a stock will go up, down, and sideways. The amount that a stock goes up or down will also fluctuate. A stock might be worth $100 now and then $200 in a couple of years depending upon a variety of factors.

The upside to higher risk investments is that you have the potential for more return. If you have a moderate risk tolerance or higher, you may be willing to put more of your money in higher risk investments for the chance of higher returns.

Lower risk investments are investments that are subject to less volatility. Bonds are often considered to be a lower risk investment as they are typically less volatile than stocks. This means that the price of bonds typically does not fluctuate as much as stocks.

There is a tradeoff to investing in lower risk investments. The investments may be less volatile, but the returns of these investments are lower than higher risk investments. If you have a conservative or moderately conservative risk tolerance, you might allocate more of your money towards lower risk investments if your goal is to preserve the value of your portfolio.

Keep in mind that just because an investment is deemed to be lower risk does not mean there is zero risk to investing in it. For example, bonds are often less volatile than stocks but have other risks associated with them such as interest rate risk, inflation risk, and credit/default risk.

Risk tolerance is relative and will vary from person to person. For this reason, there is not an exact formula to figure out your risk tolerance, but there are several things you can do to try to get a better gauge on what risk tolerance you have.

The first thing you can do to figure out your risk tolerance is to do a self assessment of your comfort level with risk. Imagine a scenario in which you put money into the stock market. If the stock market were to go down in value, how do you think you would respond?

Would you panic and want to sell all of your investments to avoid further loss? If so, you have a lower risk tolerance. Would you be okay with the volatility and keep investing? If so, you have a higher risk tolerance. You can also ask yourself the following questions to get a gauge on your risk tolerance.

Are you willing to take on more risk for the possibility of higher returns? If the stock market crashed, would you be able to continue investing? Would you be tempted to sell all your investments if the stock market crashed?

By asking yourself these questions, you can begin to formulate your ideal level of risk. If you notice that you continue to answer the questions in a manner that avoids risk, you have a lower risk tolerance. If you answer the questions in a manner that shows you are comfortable with risk, you have a higher risk tolerance.

A risk tolerance questionnaire is a tool that will help you determine your risk tolerance. The tool will ask you a variety of investing questions about your goals and hypothetical investing scenarios. Once you answer the questions, you will be provided a risk tolerance score that is right for you. Many large financial firms provide free risk tolerance questionnaires that you can find online.

A robo advisor is a digital financial advisor that helps you invest. Robo advisors use risk tolerance questionnaires to determine your risk tolerance level. Once your risk tolerance level has been determined, a robo advisor will also recommend investments that align with your risk tolerance. You can see our picks for the best robo advisors for more information.  

At the end of the day figuring out your risk tolerance can be tricky, which is why it can be beneficial to work with a financial advisor. Not only can a financial advisor help you determine your risk tolerance, but they can also help you build a comprehensive financial plan.

Up until this point, we have focused on discussing the importance of risk tolerance. However, there is another important concept to understand that works in tandem with risk tolerance - risk capacity. Risk tolerance is about how much risk you are willing to bear, but risk capacity is about how much risk you can actually bear.

For example, you might have an aggressive risk tolerance which means that you are willing to take on more risk for higher returns. However, your circumstances might only allow you to have a moderate risk capacity, which is how much risk you can truly handle. There are a couple of factors that determine risk capacity.

In general the younger you are, the greater your risk capacity and the older you are the less your risk capacity. For example, say that you are 25 years old. Since you are young, you can afford to take on more risk as you will have time to recover from investment losses.

On the flipside if you are 65 years old, you can't afford to take on as much risk as you may not have enough time to recover from investment losses. Keep in mind that your risk capacity is not always going to line up with your risk tolerance.

If you are 25 years old, you still may have a low risk tolerance, meaning you are not comfortable with taking on that much risk as you invest. Even though your risk tolerance is low, your risk capacity is high since you are young.

However, say that you are 65 years old and still have a high tolerance for risk, meaning you are willing to take on more risk for more reward. Even though your risk tolerance is high, your risk capacity is low since you may not have enough time to recover from investment losses due to your age.  

Your time horizon is the amount of time you will hold an investment before you need it. Investment time horizon is the second variable that factors into your risk capacity. In general the longer your time horizon, the more risk you can afford to take, and the shorter your time horizon the less risk you can take.

For example, say that you are 25 years old and want to invest to save for your retirement when you are 65 years old. This gives you a 40 year time horizon. Since you have a long time horizon, your risk capacity is higher than it would be if you had a shorter time horizon.

As your time horizon shrinks, your risk capacity goes down. For example, say that you are now 55 years old and only have 10 years left to reach your retirement goal. Since you are closer to your goal, your risk capacity goes down.

If you had an aggressive style of investing for the initial 30 years to grow your money, you may consider reducing your investing style to a more moderate approach with less volatile investments. Since you only have 10 years until your goal, you cannot afford to take on the same amount of risk when you had 40 years to reach your goal.

Once you understand your risk tolerance and risk capacity, you have a better idea of what you should invest in. The process of splitting up your money among different assets to create an investment portfolio is called investment allocation.

Your risk tolerance determines what your ideal asset allocation should be. For example, if you have a moderately aggressive risk tolerance, you might allocate 80% of your money towards higher risk investments for the chance of higher returns, and 20% towards lower risk investments.

This might mean that 80% of your portfolio is made up of stocks, 15% in bonds, and the remaining 5% in cash. On the flipside, if you have a moderately conservative risk tolerance you might allocate 60% towards bonds, 30% towards stocks and 10% towards cash.

The idea is to look at your risk tolerance and produce an appropriate split of higher and lower risk investments. Figuring this out can be challenging which is why you can work with a financial advisor or use a robo advisor.

After you figure out an appropriate asset allocation mix that aligns with your risk tolerance, it is important that you diversify those investments. Diversification is a process that aims to reduce the risks associated with investing by spreading available dollars across and within asset classes.  

For example, say that you have a moderately aggressive risk tolerance and decide to allocate 80% of your money towards stocks and the remaining 20% towards bonds. Say that you are a big Elon Musk fan and decide to only hold Tesla stock.

The problem that you create by doing this is that you are over dependent on a single asset. If Tesla stock goes up then great, but if Tesla stock goes down, your entire portfolio goes down. Instead, you could diversify by adding different stocks within your portfolio.

By doing this, you are less reliant on the performance of a single stock. If Tesla were to go down, you might hold other stocks in your investments that are stable or maybe going up to cushion the blow from Tesla. One of the easiest ways to diversify is to use investment funds such as index funds, mutual funds, and ETFs.

These investments funds offer exposure to a wide variety of assets and are an easy way to make sure you are diversified as you invest. When you invest in an investment fund you buy a share of the investment fund itself and get exposure to all the assets that the investment fund owns.

The bottom line is that risk tolerance is a measure of how much risk you are willing to expose yourself to as you invest. Risk tolerance levels range from conservative all the way up to aggressive. Where you fall on the spectrum will come down to your temperament and investing beliefs.

Risk tolerance is your emotional ability to handle the risk of investing, but it is important to understand that risk capacity is your actual capacity to handle risk. Understanding your risk tolerance will help you create an appropriate split between high and low risk investments.

Do not forget to diversify your investments. Doing so will further lower your risk as you are less reliant on one investment and will help keep your investments aligned with your risk tolerance. If you want to learn more about investing check out our beginners guide to investing.