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What Is Risk Tolerance, and Why Is It Important?

Risk tolerance is how much of a loss you're prepared to handle. Your goals, investing timeline and comfort level all factor into the equation.
Nov. 14, 2018
Investing, Investing Strategy
What Is Risk Tolerance, and Why Is It Important?
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Here’s one sure thing to know about investing: There is no sure thing.

Every investment has some level of risk. The more risk you take, the greater the potential returns are — and the greater the potential for losing money.

What is risk tolerance?

Risk tolerance is the ability to withstand losses when things go south. If you buy stocks, for instance, how much of a drop in the market can you stomach?

Knowing your risk tolerance helps create a game plan. In many ways it will drive how you invest, says Marianela Collado, a certified financial planner and co-owner of Tobias Financial Advisors in Plantation, Florida.

If your tolerance is low, you’ll invest conservatively. For instance, a greater portion of your portfolio might be in low-risk bonds and a smaller portion in higher-risk stocks.

» New to the stock market? See Stock market basics: What beginner investors should know

The ingredients of risk tolerance

“Everyone’s risk tolerance is going to be different,” says Charlie Horonzy, a certified financial planner and founder of Focused Up Financial in Chicago.

Here are some of the determining factors:

Goals: The purpose of financial planning isn’t to accumulate the biggest pile of money possible. It’s to decide what you want out of life, calculate how much money you need to reach those goals, and then choose an investment strategy that will deliver the appropriate returns.

Timeline: Generally you can take more risk if you have a lot of time to ride out the bumps. “If you’re going to need money in five or 10 years, that’s much different than if you have 15 years or more,” Horonzy says. The stock market’s overall trajectory across decades is upward, but there are dips and plateaus. A 30-year-old who’s saving to retire at 65 has plenty of time to wait those out. But if you’re saving to buy a house in a few years, investing that savings in stocks is too risky because there likely won’t be enough time to recoup losses if the stock market drops.

» Learn more: How to invest your savings for short-term or long-term goals

Age and life stage: “If you’re in your 80s, that tolerance can’t be as high as it would be for someone in their 30s,” Collado says. At 30, you’ve got time not only to ride out volatility but to make more money working.

Portfolio size: Someone starting retirement with a $5 million portfolio may be able to take more risk than someone with $500,000, Collado says. The person with the larger portfolio has more cushion if values drop.

Personal comfort level: Some people are naturally more comfortable with taking risk than others. “I always tell people, ‘You have to be able to sleep at night,’” Collado says. If market volatility is too stressful, that’s a signal that you need to understand better what to expect or to be in less-risky investments, she says.

The risks of ignoring risk tolerance

Investing without considering risk tolerance is like sleepwalking to the edge of a cliff. Imagine investing in stocks without thinking about how you’ll react if their value drops.

“You’re going to get woken up very fast when the market goes down,” Horonzy says.

A big danger then is freaking out and fleeing the market. Then “you’re falling into investing mistake No. 1 of selling low,” says Nora Yousif, a certified financial planner and vice president of RBC Wealth Management in Boston. A drop in the market is actually an opportunity to buy because prices are down.

» Learn more: When the stock market trembles, fight your fear and keep investing

Another danger is playing it too safe, Yousif says. You don’t take enough risk to reach goals. Taking a slightly more aggressive position to get better returns can make a huge difference over the long haul.

Take a look at the difference a 1% annual return can make for a one-time investment of $100,000 after 35 years:

Assessing your risk tolerance

Automated investing services called robo-advisors — and human financial advisors alike — have clients fill out questionnaires to help gauge their risk tolerance. (If you’re just starting out or don’t have a lot to invest, a robo-advisor is a low-cost way to get started. See our top picks for robo-advisors.)

Answer questions about risk honestly – not as you think a smart investor would.

You answer questions like this one from Vanguard:

“During market declines, I tend to sell portions of my riskier assets and invest the money in safer assets.” Possible answers: Strongly disagree, disagree, somewhat agree, agree, strongly agree.

Answer questions about risk honestly — not as you think a smart investor would.

Take risk seriously

Besides evaluating questionnaire answers, human financial planners say they spend a lot of time talking about risk so clients don’t get caught off guard when values drop.

“No one gripes about the value going up,” Yousif says. But it’s natural to wince when the market goes down and your portfolio shrinks. She stresses the normality of stock market volatility and helps clients mentally prepare so they can hang on when things get bumpy.

“It’s one thing to guess how you’re going to handle a loss, and it’s another thing to assess after you’ve lost 12%,” Yousif says. She converts percentages to actual dollars when talking about what to expect if the market drops. “That tends to get people’s attention.”

Take our quick risk tolerance quiz to begin exploring your attitude about risk-taking. The quiz isn’t intended to guide investment choices — you’ll need to consider your goals, timeline and other factors before making investment decisions — but it can give you insight into your natural tendencies.

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