What Is Your Risk Tolerance?

Risk tolerance is one of those investing concepts that sounds so simple. How much risk are you willing to put up with to make a decent return from your investments?

But the truth is that deciding what your risk tolerance looks like is not always so straightforward. Answering this question is one of the most important steps for all investors. Why? Because it’s a crucial part of how you decide which investments are right for your portfolio—and which are not.

What Is Risk Tolerance?

Ascertaining your risk tolerance tells you how much uncertainty and volatility you can stomach from your investment assets. It measures how much of a roller coaster ride you can handle without losing sleep, losing your appetite or maybe even losing your hair.

In more technical language, risk tolerance governs the amount of potential losses you’re willing to risk in order to achieve a particular investment return. It’s part of the well-known risk-reward equation: The more risk you’re willing to take on, the higher the potential return you can get—and the larger the potential losses are you might end up with.

Risk tolerance, investing time horizon and financial goals are the three big factors that shape how you invest. They are the variables in the Rubik’s cube that is your own personal investment plan. You must thoroughly understand your own risk tolerance—without that, you can’t solve the portfolio puzzle.

Define Your Financial Goals First

Before you think about risk, it’s vital to understand your financial goals. Investing for retirement is a major goal for most investors. Perhaps you also want to save for your child’s education or build up a downpayment for a new home.

While financial goals are unique for everyone, achieving them starts with the same steps. Understand what you want to achieve. How much will each goal cost? When will you need the money?

After that, you can figure out the annual return you must generate to reach your objectives.

How Financial Goals Shape Your Risk Tolerance

Say your primary goal is ensuring a secure retirement. If you’re just starting out in your career, retirement is a long way off. You have a long investing time horizon with many years to invest—that means you have plenty of time to weather market downturns and wait for stocks to rebound.

Meanwhile, an investor nearing retirement has significantly less time to recover from losses or down markets. An aging investor is approaching the day when their portfolio likely must produce income, no ifs, ands or buts.

The extra time that younger investors typically have lets them take on more risk. But even younger investors can have near-term goals and feel the pinch of limited time. A couple who are 30-year-olds may plan to retire in a distant 35 or 40 years or longer.

But what if they also plan to purchase a vacation home in, say, two years? They typically must come up with a 20% down payment to avoid the extra financial burden of private mortgage insurance (PMI). Aiming for that, they’ll have much lower risk tolerance with the investments that will provide that down payment than with their longer-term, retirement oriented investments.

What Determines Risk Tolerance?

At its core, risk tolerance is a measure of your comfort in assuming risk. The more comfortable you are with risk, the less likely you are to be risk averse in investment decision-making. A lower level of risk tolerance may lead to conservative decision-making and lower investment returns.

Temperament is a decisive factor in risk tolerance. Some people are highly conservative and eschew risk in all areas of life. Others seek it out, taking up hobbies like skydiving or mountain climbing. But the willingness to take risk in one area doesn’t always translate into the willingness to take on financial risk.

How a person comes by their money also figures into the risk equation. Take someone who has inherited a large fortune. This person knows they can shrug off investment losses. Those setbacks have little if any impact on their lifestyle. Still, this person could have a very conservative temperament. Loathe to lose investment money that they might never earn back, their risk tolerance might be low.

In contrast, an entrepreneur who frequently takes risks and learns first-hand that the gains from repeated success far outweigh the costs of occasional setbacks, is likely to be more comfortable with calculated risk.

Risk Is Always Relative

If you’re going to invest, it’s vital to understand that the market can exhibit great volatility. Stock prices go up, stock values fall, sometimes precipitously in bull or bear markets. Over time, though, the stock market grows. The broad market, represented by the S&P 500, has averaged an annual return of just over 10%, since the start of 1926.

Bear markets have averaged tumbles of 37% by the S&P 500 stock market ndex, the most commonly cited benchmark that serves as a stand-in for the entire U.S. stock market, according to Sam Stovall, chief investment strategist for CFRA Research.

Bear markets have lasted 478 days on average. What investors who dart in and out of the market tend to overlook, though, is that bull markets in that same span have averaged gains of 164%. Also, those advances last 1,576 days on average, or more than three times longer than bears.

These figures are the crux of the case for sticking with a buy-and-hold strategy in the long-term portion of your portfolio.

Worse, many individual investors panic in the face of short-term volatility. It’s okay to cash out to protect the segment of your portfolio that’s earmarked to pay for near-term expenses–like housing costs or Junior’s college tuition.

But many individual investors cash out even with the portion of their portfolio devoted to long-term growth. They bail out of stocks and stock funds, retreating to cash and bonds. Then they tend to wait too long to get back into the stock market. They often miss out on the explosive, unexpected start of new rallies. Overall, they typically sell low and buy high.

They’d be better off sticking with a buy-and-hold strategy in the long-term part of their portfolio.

The Risk Tolerance Spectrum

Your risk tolerance lies somewhere on a spectrum from conservative to aggressive. Here are the implications of each spot on that continuum:

• Conservative. You prefer to forego potential investment gains to safeguard your capital.
• Moderately conservative. You want to preserve principal, but you’re willing to take a small amount of risk in pursuit of investment gains.
• Moderate. You’re willing to balance risk with reward.
• Moderately aggressive. Your priority is longer-term investment returns, and to achieve it you’re willing to accept more risk.
• Aggressive. Maximizing investment returns is your primary goal. You will tolerate a lot of volatility along the way.

How To Determine Your Risk Tolerance

To help you figure out where your risk tolerance is on that spectrum, ask yourself questions like these:

• Do financial decisions make you anxious?
• How long is your investment time horizon?
• Are you willing to take on more risk for the potential of higher return?
• How would you respond if the value of your investments declined significantly?
• Do you have the discipline to stick to your investment strategy in a bear market?
• Would you feel pressured to sell out of your positions if the market took a sharp downward turn?

There are additional factors that can influence your risk tolerance level. Your age, income, occupation and family status are among those.

More conservative investors may prefer low-risk investments like money market mutual funds or government bonds.

Aggressive investors may favor growth stocks, complex options strategies, hedge funds and cryptocurrency.

Risk Tolerance and Diversification

Remember, when assessing your risk tolerance, it’s important to consider short-term goals separately from your long-term ones. It’s okay to treat this year’s mortgage payments, next winter’s vacation and your son or daughter’s upcoming tuition bills differently than you treat investments that will pay for retirement in two, three or four decades.

It’s okay to cash out of investments that you use to pay for near-term expenses. They may not have time to rebound from market downturns.

In longer-term investments, choose investments that you’re willing to buy and hold. Pick investments whose volatility is within whatever level or risk tolerance suits you. And while you’re at it, remember to use that other tool of long-term investors: diversification. Diversify across asset classes such as stocks, bonds, real estate and commodities.

Depending on your risk tolerance, diversify across growth and value investment styles as well as between U.S. and foreign securities, big and large stocks. Most every investor diversifies. How much and in what depends on your risk tolerance, goals and time horizon.

The Bottom Line

To maximize returns while taking on the level risk you are comfortable with, it’s important to build a balanced portfolio based on your personal investment objectives–short-term gains versus long-term stability–which will vary according to individual circumstances and goals.

Working with a financial advisor to create a disciplined and long-term investment strategy is one way to build a diversified portfolio that reflects your risk/return profile. Many advisors offer questionnaires designed to assess your risk tolerance and inform asset allocation decisions.

Many individual investors are self-directed and prefer to figure out everything from risk tolerance to their overall investment game plan by themselves. Forbes Advisor offers everything from informative reports to tools and calculators to help do-it-yourself investors.

If you have an accurate understanding of your relationship to risk, this will help you create a portfolio that offers adequate protection against serious losses while providing the upside potential that is crucial to achieving your goals.