October 11, 2020
It’s Monday morning, and you decide to check on your accounts to see how your portfolio is doing. Woof, looks like things are way down.
What do you do? Are you the type to feel panicked and think about selling, or do you shrug your shoulders and trust your portfolio can weather the dips? How you respond can clue you in on your risk tolerance. In fancy finance terms, that’s just a way to describe how comfortable you are with market variability.
Personal comfort with risk, like we just described, is just part of the picture. Your risk tolerance can be influenced by other factors, too (don’t worry, we’ll go over them). Wherever you fall on the risk tolerance scale, it’s helpful to know where you stand. Ahead, we’ll go over how you can figure out your risk tolerance and why doing so can help you put together a portfolio mix that speaks to your money goals (and that you can feel good about).
Risk tolerance essentially boils down to how much potential loss you’re prepared to handle with an investment. Now, you may be thinking, “well, that’s easy – I don’t want to lose anything!” And of course, we’re all hoping for as little downside as possible when we invest.
Like we mentioned earlier, it’s important to be honest with yourself about how comfortable you are with risk. Are you OK seeing your portfolio shoot up and down with the market? Or does even reading that sentence give you a headache and you’d rather see less variability? The answer tells you a little bit about your risk tolerance. (We’ll get into other factors that can play a role in your risk preferences ahead.)
Why is risk tolerance important? In short, the point of getting to know your risk tolerance is to help you put together a portfolio that reflects both your risk preference and financial goals.
Like a lot of things in life, risk exists on a spectrum. Generally speaking, though, there are three main types of risk tolerance: aggressive, moderate, and conservative. You can certainly fall in between two types, or closer to one extreme than the other. But here’s how each “risk personality” generally shakes out.
If you’re an aggressive investor, you’re typically comfortable taking on bigger risks to potentially score bigger returns. But you’re also (hopefully) aware that bigger risk could come with bigger losses if your investment doesn’t pan out as expected. You’re usually heavily invested in stocks, with a smaller percentage (if any) dedicated to safer assets like bonds. Typically, younger investors could fall in the “aggressive” category, since if there is a dip (or dips) in the stock market, they’ll have more time for their holdings to recover.
Moderate investors – you guessed it! – are in between, usually with a portfolio that’s a healthy mix of assets like stocks, bonds, and commodities. As you probably know, bonds are usually more stable than stocks, but also typically have lower returns as part of that security. If your investment goals require funds within the next couple of years, it can be a good idea to have a portfolio that’s balanced between risky and safe assets.
Finally, conservative investors like to take on little-to-no risk and therefore may be more heavily invested in less volatile assets like CDs, money market funds, and so on. That doesn’t mean your portfolio should necessarily consist solely of CDs and bonds, but you’ll want the majority dedicated to these often more stable vehicles.
And let’s be honest: your risk tolerance can change. It’s not necessarily a static, “forever” thing. The risk tolerance you have now may not stick with you all the way to retirement, or even be the same in 10 years. People generally become more conservative investors as they get closer to retirement, when there’ll be less time for assets to recover if the market dips. But that might be the opposite of how you feel as you near retirement. So be open to changing preferences and be honest with yourself about where you stand.
Now that you know about the different types of risk tolerance, how can you figure out where you stand? We’ll cover some of the things you’ll want to consider, but keep in mind – just about all of these factors are interconnected in one way or another. So bear with us, because some of these might start to sound a bit repetitive.
Of course, these are just generalizations. A young investor can shy away from risk just as a retiree can be willing to take a lot of chances.
Not sure what you’re willing to swing? There are dozens of “risk tolerance” questionnaires you can find online or through your financial advisor to nail it down. And we know this can be a lot to process on your own, so consider checking in with an advisor if you’re unsure about where you stand. They can help you come up with a risk that rings true to you.
It’s the question on every investor’s mind! And the answer is a bit nuanced, so stick with us.
Generally, higher risk equals potentially higher returns. Which makes sense — if you’re willing to take on more risk in the hopes of bigger returns, that seems like a fair trade-off. But, as you probably know, the reality is rarely quite that linear.
Stocks generally have higher returns when compared to bonds (have we not hammered this into your head enough times already?) But we also know there’s volatility in the stock market, and that just because something behaved a certain way in the past doesn’t guarantee it’ll happen again. We’ve certainly all heard the old adage: past performance doesn’t guarantee future returns.
Hopefully, knowing your risk tolerance can help keep you realistic about your returns. Maybe it even gives you a deeper understanding of variability in the market. If you’re an aggressive investor with a high risk tolerance, you should expect (and be comfortable with) a high degree of variability in your investment returns.
On the other hand, if you can’t handle a lot of variability and are more risk averse, your returns may be more predictable. But those returns may also be potentially smaller than they would be with riskier investments.
At the end of the day, knowing where you stand in terms of risk tolerance (and knowing who you are) can help you come up with the right investment strategy for you. Sticking to that strategy, and reassessing from time to time, is key to meeting your money goals and can hopefully give you greater peace of mind. And isn’t that what we all want with our money?
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