One of the most essential parts of getting started investing is knowing your risk tolerance level. However, many beginner investors wonder, what is risk tolerance? Risk tolerance is pretty much what it sounds like: how much risk you’re willing to tolerate when hoping to earn a profit from your investments.
However, the factors that determine your risk tolerance can be a little more complicated, and it’s important to focus on those factors and figure out what’s right for you when you get started investing. Whether you’re a first-time investor or a seasoned investor looking for a refresh, here’s what you need to know:
- What is risk tolerance?
- Risk tolerance factors
- Risk tolerance profiles
- Determining your risk tolerance
Let’s start off with a risk tolerance definition and an explanation of why it’s relevant for investors to consider.
What is risk tolerance?
Before explaining risk tolerance, it’s important to understand the role that risk plays in investing. When you invest, you are putting your money toward some enterprise, like a business, a government, a commodity, or some collection of those things. You’re betting that the enterprises you’re invested in will continue to grow, increasing their total value, and your share of the pie along with it.
However, that necessarily involves some risk. After all, businesses fail all the time, and even government bonds, which are typically thought to be low-risk, could lose value if the government fails or falls into a prolonged depression—though that is much less likely than a business going under.
Different entities that you can invest in come with different levels of risk and potential for reward. Those government bonds are not exactly a get-rich-quick scheme because, even though there’s not too much risk involved with them, it’s unlikely that they will yield massive profits quickly. A brand-new tech startup, on the other end of the spectrum, might promise huge returns for early investors. But there’s a good chance they won’t make it on the market.
That is why every investor needs to determine what kinds of investment strategies are appropriate given their risk tolerance level. Here is a simple risk tolerance definition:
- Risk tolerance is the level of risk and uncertainty that you can afford to take and are willing to take.
*Note: Risk tolerance is different than risk capacity which is how much risk you can objectively afford to take.
Your risk tolerance will determine the makeup of your portfolio, or the collection of investments that you choose to make and manage.
This is not a matter that is set in stone. Your risk tolerance is likely to change with your age, income, knowledge, marital status, and other important life events, such as buying a home, a child’s college costs, or retiring. Investment risk tolerance is determined by a few different factors like these that we will discuss in the next section.
Any source that offers you investment tips without knowing anything about you is likely giving you poor advice. A responsible way to decide what investments and strategies are best is to start by deciding whether you’re willing to take big risks for the chance at big profits, or would prefer a safe and more sure approach for lower potential reward.
One strategy that many investors use to minimize the total risk that they are exposed to is diversification. The principle behind diversifying your portfolio is basically that you want to avoid having all your eggs in one basket. A large, diverse investment portfolio might contain a mix of:
- Stocks, bonds
- Real estate
- Other investments
ETFs and index funds are often a great way to get started investing in a diverse portfolio. Some holdings might be riskier to help grow the portfolio, while others might be steadier to help keep the portfolio from suffering serious losses. By adding more stocks to a portfolio, for instance, money managers can make the portfolio more aggressive. Alternatively, they might scale back risk as an investor by putting more of your funds into bonds.
Risk tolerance factors
Your personal risk tolerance is determined by a few factors. Before deciding on a portfolio that’s right for you, it’s important to determine where you fall with respect to each of these categories.
What are your investing goals? If you want to make money quickly—or make a lot of money—you may need to become more comfortable with making higher-risk investments. That’s because lower-risk options, like bonds, index funds, and dividend stocks all embody a slow-and-steady strategy.
On the other hand, options like individual company stocks might present the possibility of faster growth; imagine if you had invested in Facebook or Apple during their early days! However, for every Facebook, there are hundreds of apps that never find success. Investing in individual companies that promise short-term growth is almost always riskier, but if your goals are to make it big, you may be pushed more in that direction.
Age and time horizon
Your age is also a relevant factor when determining your investment risk tolerance. Younger investors have plenty of time to ride out the bumps in the stock market, so financial advisors and robo-advisors may often suggest that they choose a more aggressive, risky portfolio allocation. It may be risky in the short term, but because the stock market has historically trended upward in the long term, it is likely to turn out well.
Older investors, on the other hand, may be more comfortable with a lower-risk portfolio that consistently grows in a dependable way. Many older investors may prefer to invest in dividend stocks that periodically pay out money that can be used to supplement retirement savings or simply add a little disposable income to a retirement portfolio.
Personal comfort level
Of course, in addition to more “objective” factors like your age and goals, there is also the subjective factor of your own comfort level. Maybe you’re just the type of person who likes to gamble a little, and investing in new startups or interesting growing companies is just your thing. Or maybe, even if you’re younger, you’re more comfortable with a slow-and-steady-wins-the-race approach, and you’re satisfied to keep all your money parked in an index fund.
Ultimately, it’s a wise idea to talk through your own goals and time horizon with a financial advisor, and think through the ways that your own personal preferences could be adjusted to suit a more advantageous portfolio.
When determining your own personal preferences and goals, you’ll likely come across a few terms that describe your financial risk tolerance profile.
Risk tolerance profiles
Roughly speaking, your investment risk tolerance can be broken down into one of three different levels:
An aggressive investor or speculator is willing to use high-risk strategies in the quest for fast, exceptionally high profits. However, this approach also means to risk losing a lot of money. High profits and high losses are two of the possible outcomes to aggressive investing strategies.
A moderate investor believes in balancing a portfolio through asset allocation and diversification, spreading risks among many different products and strategies. It is also likely that moderate investors will diversify by risk level, including some relatively low-risk choices along with a few relatively higher-risk ones. A moderate hopes to either match the market and keep up with inflation, or to gain a slight edge. However, a moderate is also a realist, and does not buy the “get rich quick” argument speculators are drawn to.
A conservative investor is willing to accept lower returns for the safety of their capital. So, they are likely to pursue insured returns from money market accounts, guaranteed returns from annuities, or other low-risk investments. However, these returns are going to be quite low. An evaluation of the after-tax, after-inflation return might reveal that ultra-conservative returns lose money.
Determining your risk tolerance
As you consider the investment portfolio that’s right for you, you should sit down and take some time to determine what your personal level of investment risk tolerance might be.
Deciding your risk tolerance is a balancing act. Most people do not want to take risks that are simply too high; and being too conservative could mean leaving money on the table, or losing out due to inflation. Somewhere in the middle—probably in the range of “moderate”—is where most people find their most suitable financial risk tolerance level.
However, it’s always a good idea to work with a professional financial advisor or wealth planner who can help you better understand your options. You might realize that, after better understanding the world of investing, you are actually more comfortable taking risks than you previously thought. Alternatively, you might learn that risks are much higher than you believed, and that it’s wiser to scale back your risk tolerance.
Ultimately, developing a better understanding of investing and the many factors that go into determining your investment strategy is the most important first step you can take in order to avoid investing mistakes. And, for a bird’s-eye view of your finances that you can use to keep track of your investments as well as any other accounts, you can always use the Mint App. It’s free, and it can help you keep tabs on everything that you need to know about your personal financial profile.