What is risk tolerance?
Investment risk tolerance is a way to measure your willingness and ability to handle a loss in the value of your investments due to market volatility.
How much risk are you willing to take?
Your willingness to take risk is tied to your personality and how much you’ll worry about your investments. If you worry when the market changes, you probably have a lower risk tolerance and might prefer investments less likely to lose money but offer lower return. If you’re willing to leave your money alone and stick to your long-term investment plan through ups and downs in the market, you probably have a higher risk tolerance.
If you aren’t sure what you’re comfortable with, ask yourself:
- Do I need the money I’m investing in the short term or long term
- How would I react if my investment dropped significantly in value?
Understanding your risk tolerance can help you prepare for market changes and save you a lot of stress. You can determine your risk tolerance by completing this Investment Personality Questionnaire | PDF 2.6 MB.
What is your ability to recover from investment loss?
The younger you are, the more time you have to recover from market downturns – particularly when it comes to your retirement savings. If you’re in your 20s and are saving for retirement, you should be better able to handle short-term changes in your investments. Factors like your income and other assets, also play a role in your ability to take on risk.
That’s what “risk capacity” is – your ability to survive financial loss if your investments take a steep drop. If you have a higher risk capacity, you can stay the course and hopefully rebuild your assets over time if the market drops significantly. If you have a lower risk capacity, you’d be severely impacted if the market dropped. For instance, if you’re retiring soon, you probably wouldn’t want to put a big chunk of your savings into a risky investment.
That’s why it’s important to adjust your risk tolerance as you age and your life changes.
Types of investment risk
When it comes to determining your risk tolerance, you’ll want to consider the various risks that go along with investing.
Inflation risk
The possibility the money you’ve invested will decline in real value because of inflation. In other words, the rate of return you get on your investments is lower than the rate of inflation on the goods and services you’ll buy in the future.
Market risk
The likelihood that an investment market, such as the bond market or stock market, will fall in value, including the investment you’ve chosen. Called market volatility, there can be many reasons this happens. Use these resources to help educate yourself about market volatility, ease your worries and help avoid making emotional investment decisions.
Business risk
The risk of investing heavily in a particular industry or environment. That particular industry can develop an issue that doesn’t affect other industries, for example, a strike or lack of raw materials.
Timing risk
The possibility that you could buy or sell an investment at the wrong time. People try to buy low and sell high, but timing the market takes more experience than most of us have.
For the first risks, the best way to manage them is to diversify your investments with a mix of investments across different sectors, markets, countries, and types of investments. To help manage timing risk, you might consider purchasing your investment using dollar-cost averaging.
With dollar-cost averaging, you invest the same amount of money on a regular basis, regardless of the price of the investment. Over time, investing this way can lower your average cost per unit — compared to what you’d have paid if you'd bought all your units at the same time when they were more expensive than the average.
Levels of risk tolerance
Risk tolerance comes down to your comfort level and preferences and your real-world financial situation. It’s important for these 2 areas to line up. If you’re very willing to take risk, but unable to recover from market drops, you could run into real challenges. Once you determine your risk tolerance, you’ll be able to recognize the type of investor you are.
- Conservative: Your risk tolerance and capacity are lower. Your investments will likely include fewer stocks and more bonds or money-market assets (which usually offer steady returns with less fluctuation in price).
- Moderate: You might be somewhere in the middle, perhaps someone with a higher risk tolerance but a lower risk capacity. Your investments might include a mix of stocks and bonds for a more balanced approach.
- Aggressive: You have a higher risk tolerance and capacity and accept that you might see big swings in your investment value over time. You’re likely looking for bigger potential returns. Your investments are likely mostly stocks (as opposed to bonds) from big and small companies.
You can even choose investments that offer diversification and are prepared for specific levels of risk.