What Is Risk Tolerance?

Risk tolerance refers to your willingness and financial capacity to take on losses when investing. Of course, no one likes the idea of potentially losing money, but all investing involves some degree of risk. Understanding your risk tolerance can help you build a portfolio and invest your money in a way that’s appropriate for your goals.

Levels of risk tolerance

Risk tolerance varies from person to person. Some investors are more risk-averse than others depending, in part, on their age, time horizon, and goals. Generally, there are three main types of risk tolerance.

Aggressive risk tolerance. Investors are willing to take on more risk in order to potentially earn higher-than-average returns. They’re also less sensitive to the ups and downs of the markets, understanding that volatility is normal and expected. An aggressive risk investor tends to invest more heavily in equities in pursuit of higher portfolio returns when the market is doing well. But keep in mind that they could also suffer significant losses if the market is doing poorly.

Moderate risk tolerance. Investors in this category are a little more sensitive to risk compared to the aggressive risk investor. Moderate risk investors prefer to take a balanced or middle-of-the-road approach in building their portfolio, splitting their investment among higher-risk and lower-risk assets, such as stocks and bonds. A 50/50 or 60/40 split between stocks and bonds is a common example of a moderate portfolio.

Conservative risk tolerance. These investors are more risk-averse. They prefer to invest in a way to avoid huge losses, usually focusing on preserving their principal while earning a modest return – rather than seeking aggressive growth. Retirees or those approaching retirement tend to fall under this category.

Determining your risk tolerance

How do you know which risk category you fit in? A number of factors can influence your personal risk tolerance. Here are five to keep in mind. 

1. Personal comfort with risk

This refers to your willingness to take on risk, and it’s subjective. At the end of day, you could have a long time horizon and a robust portfolio, but if you’re someone who is naturally risk-averse, you may not feel comfortable investing in a way that could expose you to unnecessary risk. Because your comfort level with risk is subjective, there’s really no right or wrong answer here. But it’s important to be honest with yourself when assessing your willingness to take on risk, and let it help guide you in your investment decisions.

2. Portfolio size

Remember that risk tolerance is about your willingness as well as your ability to take on losses. The size of your portfolio can help give you a sense of your capacity to take on risk. Generally speaking, the larger your portfolio, the more risk you’re able to take on. For instance, an investor with a $5 million portfolio might be able to better absorb losses or manage volatility than someone with a budding $100,000 portfolio.

3. Time horizon

Your time horizon is simply how long you plan on staying invested to reach your financial goals, and it typically depends on things like your age, financial goals, and investment plan. For example, an individual who is a long way from retirement would generally have a longer time horizon than someone who is investing money to put in a down payment for a home in the near term.

Investors with a longer time horizon can usually take on or tolerate more risk, as they have more time to ride out the ups and downs of the market in hopes of earning higher returns over the long term.

4. Age

Age is closely related to time horizon. Young people tend to have a longer investment time horizon, so they’re typically able to take on more risk in their portfolios.

For instance, the portfolio of a young professional who is saving for retirement will likely look different than that of someone who is near retirement. Individuals with a longer time horizon may choose an asset allocation designed for growth. The 80/20 split is a common example, where the portfolio holds 80% stocks and 20% bonds.

On the other hand, someone in their 60s generally has a lower tolerance for risk, as they’ll likely need to tap into their retirement account if they’re retiring soon. So their portfolios may have a more conservative target asset allocation – holding more bonds than stocks.

That said, keep in mind age is only one factor – it’s not the sole determinant of your risk tolerance. A young investor may shy away from risk just as a retiree may be willing to take on more risk. It all goes back to your personal comfort with risk.

5. Goals

Your investment goals will also impact how much risk you’re willing to take on. Some investment goals have a short time horizon while others have a longer time horizon. And investors with a short time horizon may not feel comfortable investing aggressively, as they’ll need their money in the near term. 

Risk tolerance can shift over time

Because factors like age, time horizon, and goals will naturally shift over time – so can your risk tolerance. The degree of risk you’re willing to take on now may not be the same 30 years down the road. It’s important to revisit your risk preferences from time to time to ensure they’re aligned with you goals and comfort level.

If you’re unsure of where you may fall on the risk tolerance scale, consider working with a financial advisor who can help make an assessment. There are also free risk tolerance questionnaires you could check out online as a starting point.

Bottom line: Understanding your risk tolerance can help you decide the right investment strategy for your financial goals and hopefully give you greater peace of mind when it comes to investing.