Investing > Risk Tolerance Explained

Risk Tolerance Explained

All investments come with risk. The question is, how much risk are you willing to take for that pot of gold at the end of the rainbow?   

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Updated March 03, 2022

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What comes to mind when you hear the word ‘risk’?

Investment risk comes in many forms, like the volatility of a specific stock or ups and downs in the market. For many people, risk is synonymous with loss and uncertainty. But for others, risk means taking a bigger leap of faith for larger profits. Regardless, nobody likes to see their capital wiped out by an ill-timed, ill-fated investment. 

Thankfully, we don’t have to rely on dumb luck and instinct to determine whether the risk is worth taking. Profit and danger often go hand-in-hand in investing. The question is, what types of assets can help you achieve your financial goals without taking on too much risk? Or conversely, how much risk do you have to bear for it to be worth it? 🤨

In this article, we’ll take a closer look at determining and setting up your risk tolerance. We’ll also talk about how your risk tolerance guides your investment style and asset allocation.

Sound good? Let’s jump in! 🚀

What you’ll learn
  • What is Risk Tolerance?
  • How Does Risk Tolerance Work?
  • How to Set Up Your Risk Tolerance
  • Tips to Keep in Mind
  • Understanding Risk Capital
  • Conclusion
  • FAQs
  • Get Started with a Stock Broker

What is Risk Tolerance? 📚

Hypothetically, how much loss do you think you can bear before you sell your stocks? That’s essentially what risk tolerance is: how comfortable you are when stomaching a loss of value in your investments. 

In many ways, your risk tolerance drives the way you invest and how you allocate your assets. It helps you create a well-diversified portfolio that balances profits and losses based on your comfort level with risk. Not only that, but you’ll learn what asset types suit you the best when you take your risk tolerance into account. 

Keep in mind that everyone has a different risk tolerance—that’s why copying someone else’s portfolio is never a good idea. Your investor buddy might be more inclined to take huge losses while you prefer to keep your principal. Even your own risk tolerance won’t stay static forever as you become more familiar with your investment style and the markets overall. 

How Does Risk Tolerance Work? 👷‍♂️

Anyone can have a high risk tolerance when the market is rising and thriving. The real challenge comes when the stock market tanks, and losing money becomes the norm instead. How would you react to loss if you’re uncertain whether you’ll recover your capital?

Let’s time travel to March 2020, when the COVID-19 pandemic became very real for the world and investors. In a few months, the S&P 500 dropped by 34% and would have fallen further if not for substantial bailout efforts by the Fed. Businesses folded, and unemployment was at an all-time high. It was an unprecedented time with a high level of uncertainty about the effects of the pandemic on the economy.

COVID-19 pandemic crash
Events like the Covid-19 Crash are a perfect example of why assuming too much risk can be dangerous. Image by TradingView.

This is a great scenario to be in when determining your risk tolerance—would you take all your investments out in the face of a volatile market to prevent any further losses or would you stay put? An investor with lower risk tolerance is more likely to prioritize the safety of their portfolio and sell their assets, while aggressive investors would wait for an upward trend. 

There’s a saying by Rob Arnott, “in investing, what is comfortable is rarely profitable,” which is essentially how risk tolerance works. If you’re afraid of even temporarily losing your capital, you’d most likely settle for lower-risk instruments and lower returns that come with them. On the other hand, you stand a higher chance for better return potential in exchange for dealing with sudden downdrafts or even outright losses.

In general, there are three basic levels of risk tolerance. You may find yourself grouped into one of these categories or move across all three as you go through your life stages. We like to think of these categories as a sliding scale with three known points—you’re not meant to put yourself neatly in any of these categories. Your job now is to figure out where you belong on the scale. 

Aggressive Risk Tolerance 📈

The main priority for an aggressive investor is to get as much return as possible for their investment capital. They tend to be well-versed in the market and prefer assets with dynamic price movements like equities and real estate since these instruments bring in big money. They might even like to micromanage their trades to make the most profit. 

A huge plus an aggressive investor got going for them is that they’re less likely to panic sell in a financial crisis. In fact, some might even follow the golden investment rule of ‘buying low and selling high’ in the face of a dip in the stock market. When you look at the portfolio of an aggressive investor, it’s most likely filled with huge profits and losses—not all gambles come to fruition after all.

Moderate Risk Tolerance ⚖

An investor with a moderate risk tolerance plays for both teams. They’re not too aggressive or too conservative and tend to have a more balanced portfolio. A moderate investor might set aside a certain percentage or amount of money they’re willing to lose for more profit. 

Conservative Risk Tolerance 📊

An investor with conservative risk tolerance is more focused on preserving their capital, so they tend to avoid risk as much as possible. They’ll sell as soon as they see any signs of danger looming on the horizon. For them, a smaller return is a small price to pay to insure their portfolio’s security and safety. 

The drawback, however, is that there’s no such thing as absolute security when you’re investing. If you’re a conservative investor, you’d be closing yourself off to many investment instruments. Not only that, but the profits that you get might not even cover the inflation rate, which means you’d ultimately be losing money (albeit slowly). 

How to Set Up Your Risk Tolerance 🏗

Risk tolerance doesn’t just boil down to your instincts. It requires a thorough understanding of your investment style and your comfort level with risk. To help get you started, here are a few questions that you should ask yourself to determine your risk tolerance. 

What Are Your Investing Goals? 🏁

For most people, investing isn’t just about accumulating the biggest pile of money. You might be investing to save up for a comfortable retirement, your kid’s college fund, or even your first house. No matter what it is, knowing where you want to go is the first step in evaluating how comfortable you are with risking your principal.

Not only that, but it also helps you find out how much money you need and establish a timeline for how long it’ll take to reach your goal. Generally, younger investors have a longer timeline, which means they can afford to take on some risks even if the market crashes. If you’re five years away from retirement, you might want to be more cautious with your money.  

That doesn’t mean that your age is the only thing that matters when setting your risk tolerance, though. Let’s say you received a huge bonus today—you might feel more inclined to invest in riskier securities even if you’re just two years away from retirement. 

Conversely, you might have gotten caught in the 2008 financial crisis and became less trustful of risky investments. Other than your age and retirement goals, there are many factors at play, so be mindful of them when allocating your assets.

If you’re aiming to be a millionaire by the time you retire but are only projected to be in the $100k area by that time, you might have a problem on your hands. It’s very common for your risk tolerance not to align with your investment goals. In this case, the best thing you can do is decide whether to take on more risk than you can stomach, adjust your investment goals, or opt for other wealth accumulation strategies.

When Will You Need the Money? 💵

As we’ve mentioned, younger investors tend to have a longer timeline, which means they can afford to take more risks when investing. However, they might not have the financial flexibility that older investors have as they have just started their careers.

For example, you’d be less likely to invest in risky instruments if you have less than $200 leftover from your paycheck. Although investments can help increase your net worth, you should first determine if you have enough financial stability to cover emergencies like unemployment and medical services without withdrawing your investments. If you can afford to cover your expenses for the next few years, you can invest in riskier instruments and leave them to grow for a higher profit down the road. 

Can You Wait Out Major Losses? 💸

Even with a portfolio of reliable companies, you’re likely to lose a lot of your investment value when a crash occurs. Take the 2020 stock market crash, for example. 

When you look at it retrospectively, many people who waited for the market to rally stayed relatively unscathed or even became profitable just a few months later. But if you need the money for rent and expenses, you’d probably panic sell and lose the opportunity to recoup your losses. 

2020 stock market crash
Historically, crashes have always set the stock market back temporarily, returning investors’ gains eventually. Image by TradingView.

Considering how the stock market has a generally upward trajectory with dips and plateaus, you can take on more risks if you can afford to wait out significant crashes. Do you have the patience and funds to sustain yourself while waiting for the stock market to recover? This becomes a critical factor to consider when you’re setting up your risk tolerance. 

What is Your Comfort Level with Risk? 🎛

Let’s say you’re planning to withdraw your investment in 20 years. In the second year, the stock market dips, and you lose 5% of your portfolio. How would you react to this loss? If you’re very concerned and seriously considering withdrawing your investments, you probably have lower risk tolerance. 

Some investors mitigate their risk tolerance by allocating a certain percentage of their portfolio to potential losses. That percentage depends on how comfortable you are to risk, of course. Typically, investors with a limited budget would allocate a much smaller portion, while someone with no outstanding debt would be more willing to lose more for more profits. 

Are You Sure You Know How It Works? 🤔

Theoretically, working with your risk tolerance is simple. If you’re a conservative investor, you go for low-risk/low-reward assets like bonds. But if you don’t mind losing more in hopes of more profit, you can go for higher risk/higher reward instruments like stocks and futures. 

But in reality, many factors come into play on how ‘safe’ your assets really are. A stock that was ‘safe’ yesterday might become volatile today. Even risky assets like obscure penny stocks might not have high growth potential. This leaves a lot of room for guesswork and instinct on something you want to be sure about.

There are several numerical formulas that you can use to put a number on your risk tolerance. For example, the Sharpe Ratio is one of the most popular risks/return measures used in the finance industry—it describes how much excess return you’ll receive in exchange for the additional risk you bear. 

Although formulas like this can tell you how risky your investment moves are, they always depend on arbitrary metrics that make them fairly unscientific. As human beings, we make many personal judgement calls that are arbitrary numbers to the formula, like your investment timeframe and risk-free benchmark. Without a thorough and fundamental analysis, you might find yourself accidentally gambling instead of investing.

What to Keep in Mind When Choosing Your Risk Tolerance 📝

Simply knowing what type of investor you are isn’t enough. You also have to decide if your risk tolerance can support your investment goals and take you to the finish line. In this section, we’ll focus on a few things you can do to make this decision more manageable and streamlined. 

You Can Get an Expert to Help Manage Your Risk 🤖

If you don’t want to make the calculations with tedious numeral formulas, you can get robo-advisors to help you. Robotic financial assistants have evolved beyond their ‘beep boop’ stages in yesteryears. Now, by filling out a form or choosing a risk tolerance, they can very quickly pick out the right assets for you. 

What is a Robo-Advisor
Robo-advisors are probably the easiest investment avenue out there nowadays, but their aim to match average stock market returns might be insufficient for more ambitious investors.

There are many benefits to using a robo-advisor. For one, they’re created by financial management companies to reduce their workload, so they’re relatively inexpensive compared to human financial advisors. It might take a bit of research to find the most suitable robo-advisor for you, but once you do, they’ll save a ton of time with automated investments. If you’re looking for a free robo-advisor, we have nothing but good things to say about M1 Finance.

That’s not to say that humans are entirely obsolete, though. While robo-advisors can pick out the most profitable assets for your risk tolerance in just seconds, human advisors offer you valuable information beyond financial services, like education, communication, and factoring real-life circumstances into your portfolio. You can even chat with your advisor about your risk tolerance at length to start a plan, and they’ll hold you accountable—that’s something that robots can’t do for you. 

Regardless of whether you prefer humans or robots, it’s always a good idea to be on the same page as your broker about your risk tolerance when you’re investing. Even if your tolerance changes later down the road, having these options can significantly benefit you and your portfolio.

A Conservative Risk Tolerance is Also Risky 👨‍🏫

We get it—it’s rough losing money on your investments, so you try to preserve your investment as much as possible. But do you know that you might end up losing money instead if you invest too conservatively?  

For one, you get a lower rate of return when you play it super safe with your investments. Your profits might not be able to outpace the inflation rate, meaning you might be living with the anxiety of losing your investment capital for basically no profit.

Besides that, you have to consider the role of the USD interest rate if you’re buying bonds. Generally, you’d yield less for bonds that you already own when the USD interest rate is low. On the contrary, if you can stomach a bit of risk, you can plan your entry strategically and sell when the Fed increases interest rates to take advantage of the bond price increase that might ensue.  

Make Sure You Have Enough Risk Capital 💰

Everyone should have an emergency fund in case their life gets derailed by unemployment or other emergencies. It’s the same way in investment—you should set aside some risk capital, a sum of money that you can use on high-risk/high reward instruments or speculative activity. 

With a healthy amount of risk capital, you have more leeway in managing your risk tolerance. For example, an investor with a high net worth and risk capital can afford to take on more risk than the average Joe. 

This would also pay off in the long run since you can invest safely in riskier assets without compromising on your quality of life. In general, the smaller the percentage of your overall net worth that your portfolio takes up, the more aggressive your risk tolerance can be. 

Unfortunately, those with little to no net worth or risk capital can also be tempted by “easy and large” profits offered by speculative assets like futures or options. Not only is it essentially gambling at this point, but you’re also not likely to make good decisions when trading with your rent money. If you take on too much risk from the get-go, you might not even stay in the game long enough to cash out.

Conclusion 💭

In a nutshell, risk tolerance refers to how comfortable you are with losing the value of your investment. A few factors come into play when determining your risk tolerance, like your age, investment goals, income, and your comfort level with risk. Most importantly, your risk tolerance shows you what you prioritize in your investment strategy—high growth or conserving your capital.  

Most investors don’t fit neatly into any one category, and you’ll find yourself moving up the risk tolerance scale as you mature and become more familiar with investing. In any case, it’s always a good idea to use a robo or human advisor to help you get the most out of your portfolio. 

Risk Tolerance: FAQs

  • How Do You Calculate Risk Tolerance?

    You can calculate your risk tolerance by answering a questionnaire on how you assess risk, your perception of risk, and the choices you make to seek out risk. The length of the questionnaire depends on the provider, but generally, questionnaires with at least 20 questions are proven to be more accurate. You can also opt for robo advisors since they assess your risk tolerance and give you suggestions for suitable assets. 

  • What is the Role of Risk Tolerance in the Decision Making Process?

    From making intelligent decisions to capitalizing on a bear market, your risk tolerance drives how you invest and allocate your assets. Because of this, it helps you create the best investment strategy that balances profit and loss. Not only that, but your risk tolerance can help you determine if you're more likely to make emotional decisions with your investments. 

  • What is a Good Risk Tolerance Level for a 20-Year-Old?

    A 20-year old would have a longer investment horizon, which means you have more time to recover in case of a crash or dip. However, that also depends on your investment goals and when you want to withdraw your investments. For example, if you aim to use the returns to buy your first apartment in 10 years, you might want to go for something more secure. But if you're investing to retire, you can afford to put more money in the stock market to maximize your profits.

  • What Are the Three Drivers of Risk Tolerance?

    The main driver of risk tolerance is the fear of losing money—the more worried you are about losing money, the lower your risk tolerance. Besides that, changes in your spending habits and consumer sentiment levels are also drivers of risk tolerance. These factors come together to show you how secure you are with your financial status and the state of the economy, which bleeds into how willing you are to spend or lose money in investing. 

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