What is risk tolerance, and why is it important?

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Risk tolerance definition

Risk tolerance is your ability and willingness to stomach a decline in the value of your investments. When you’re trying to determine your risk tolerance, ask yourself how comfortable you will feel maintaining your positions when the stock market is experiencing large declines.

There is an old Wall Street adage that says, “You can eat well or you can sleep well.” Eating well refers to the observation that over long time horizons, holding higher-risk assets (such as stocks) allows investors to accumulate significant wealth. However, that comes at a price, as stocks can be quite volatile, causing investors to lose sleep.

Why risk tolerance is so important

Your risk tolerance plays a crucial role in your game plan for growing your money without stressing about it on a daily basis.

If you don’t have the stomach for dealing with the risks of losing your principal, even temporarily, you’ll have to settle for lower-risk investments and the lower returns that come with them. Investments with the potential for higher returns often come with a higher potential for sudden downdrafts or outright loss.

With an understanding of your risk tolerance, you can create a strategy for your investments that will help you balance the worries of volatility with the potential for bigger returns when looking at the large picture.

How risk tolerance works

Anyone can have a high risk tolerance when stocks are rising. However, the best time to truly assess your risk tolerance is when the market is falling.

Think back to March 2020. The market tanked. Unemployment numbers soared. The world confronted an unprecedented level of uncertainty, wondering whether COVID-19 would destroy the economy.

What was your risk tolerance then? Did you hang on through those tough times? If you sold stocks in the midst of the panic, your risk tolerance was low. Or, were you willing to invest more to take advantage of the market sell-off? If so, your risk tolerance was high, and it has served you well as the stock market sets record-breaking numbers.

Types of risk tolerance

There are a few different types of risk tolerance:

  • Conservative risk tolerance: With this mindset, an investor is focused on preservation of capital and the avoidance of downside risk. That means lower returns, but the investor will settle for that in exchange for steering clear of any wild swings in value. An older investor who is closer to retirement will likely have a fairly conservative risk tolerance.
  • Moderate risk tolerance: Moderate risk tolerance keeps a foot in two camps: conservative and aggressive. A classic example includes the traditional 60/40 allocation between stocks and bonds. This strikes a balance between some money invested for growth (stocks) while maintaining an eye on stability for income generation (bonds) at the same time.
  • Aggressive risk tolerance: With an aggressive risk tolerance, the majority of an investor’s portfolio is allocated toward riskier assets such as stocks and real estate. These offer the prospect of higher returns over time. That time component is a key ingredient, though. The investment has a greater chance of losing value in the interim.

How to determine your risk tolerance

Determining your risk tolerance depends on answering a few key questions:

  • What are your investment objectives? Are you investing regularly and looking to grow the value of your nest egg? Or do you already have a decent nest egg and rather than grow it, are you looking to preserve it and live off of the income it generates? Each will convey a different tolerance for downside price risk.
  • When do you need the money? Your time horizon is a crucial piece of the equation. The sooner you need the money, the lower your risk tolerance should be. Money you need for a home down payment next year has an entirely different time horizon than the money you’re accumulating for retirement that is still years away.
  • How would you react if your portfolio lost 20 percent this year? Assessing your risk tolerance involves thinking about hypothetical challenges and worst-case scenarios. If your investment lost 20 percent of its value, would you lose sleep at night and pull out all of your funds? Or would you leave it invested and consider putting even more money in the market to capitalize on the discount?

Risk tolerance vs. risk capacity

It’s important to assess your risk tolerance in relation to your capacity to take on risk. These two components should be aligned.

For example, if you are a 20-something saving for retirement in your workplace 401(k), you have a large risk capacity. You may have 45 or 50 years until retirement, which means you can afford to invest aggressively with the capacity to withstand the potential for a drop in value. However, your risk tolerance may not match up to that. You may be a nervous investor.

Thinking about risk in the big picture

When you’re early in your career and beginning to invest, it’s important to have a long-term vision. It can be tough watching your investments decline from one day to the next. However, if you aren’t investing that money for tomorrow or next month, you have to recognize that it’s the end game that really counts.

The stock market may average a 10 percent annual return over time, but it doesn’t deliver those 10 percent gains every year. Some years, it may be down more than 30 percent, whereas others, it might be up more than 30 percent. Measure the growth of your returns over time — not every single day. As you get closer to retirement, that’s when you will need to scrutinize your ability to deal with downside risks. Make sure that you are re-evaluating your risk tolerance and risk capacity to make the necessary adjustments.

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