What Is Financial Risk Tolerance?
May 12, 2021
What Is Financial Risk Tolerance?
May 12, 2021
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When you hear the word “risk” in association with your money and investing, what do you feel? Are you excited about the opportunity for high returns or feel a thrill of investing? Or do you worry that you’ll lose a portion of your nest egg—or everything? Do you think risk is naturally par for the course with investing? Or does it keep you up at night?
Understanding your risk tolerance helps you make smarter investment decisions—but it’s not as simple as just taking a questionnaire online. There is an emotional element involved in this otherwise analytical construct. To get to these deeper emotions, your financial professional(s) should go beyond the assessment they’ll likely give you and have an in-depth conversation about your fears, concerns, and goals.
What Is Risk Tolerance?
In financial terms, risk tolerance is the degree or variability in returns a person is willing (or capable) of withstanding in their investment portfolio—essentially, how much loss an investor is willing and able to endure in their investment returns. A higher risk tolerance level carries more uncertainty as to returns. Risk tolerance considers market risk—market swings, volatility, economic and political events, regulatory factors and changes, and interest rates. Risk tolerance is a very important part of financial planning and investing. It’s essential to understand your risk tolerance because it helps determine the appropriate asset allocation for your portfolio. Be realistic about your ability to withstand swings in the market and, by extension, the value of your portfolio. A misaligned risk level in your portfolio in comparison to what you can actually tolerate can cause you to a) “panic” sell if you take on too much risk or b) feel disappointed with the returns if your portfolio is invested in a lower risk model.
A concept from behavioral psychology, loss aversion—the fear and avoidance of loss—can play a bigger role in financial decision making than the anticipation of gains. This phenomenon can significantly impact your risk tolerance level. According to Sulaiman (2012), gender does not have a significant impact on risk tolerance (though, it was previously commonly accepted that men are more risk tolerant than women), while higher education and/or income levels generally correlate with higher risk tolerance.
What Factors Influence Risk Tolerance?
The most common factor associated with risk tolerance is your age. In general, younger people with a longer time horizon before retirement are often more comfortable with and able to take greater investment risks because they have more time to weather the short-term ebbs and flows of their investments. Older people closer to retirement generally need and want to protect their nest egg as they will need access to the funds in the near future. Other factors that can influence a person’s risk tolerance are their overall income, investment/financial goals, net worth, and amount of disposable income. Generally, the higher their net worth and disposable income, the greater risk they can afford to take. Of course, even considering these factors, risk tolerance is personal and comfort level varies by individual.
Evaluating Your Risk Tolerance Level
There are many risk tolerance questionnaires/assessments online; your financial professional should also be evaluating your risk tolerance level as part of your financial planning process. If you’re a do-it-yourself investor, take a risk tolerance assessment online (here’s an example assessment from Rutgers) and align your portfolio accordingly. It may be valuable to review historical returns for different asset classes (e.g., equities, bonds, etc.) for an understanding of how much your investments might lose in a bad year (or over several bad years). Remember: There are many factors that can affect your risk tolerance, including the length of time before retirement, your future earning capacity, and your other non-investable assets (like your home).
Some questions your financial professional might ask to determine your risk tolerance level:
- How much money are you willing to—or comfortable with—losing?
- How diversified do you want your portfolio to be?
- What emotions do you think you might feel if the markets declined significantly?
- What amount of money loss might keep you up at night?
- Are you more concerned with losing money or losing out on the potential for greater returns?
- Do you plan to track your investments daily? (This could be a sign of unease if you feel the need to monitor your money every day.)
Risk Tolerance Levels
There are three buckets for risk tolerance; even so, keep in mind that risk tolerance is a spectrum, and people fall across the entire spectrum with varying levels of risk tolerance. Experienced and knowledgeable financial advisors can model portfolios to nearly exactly match an investor’s self-reported risk tolerance level.
Conservative investors have low risk tolerance and are comfortable and willing to accept little to no volatility in their investment portfolios. Preservation of their principal and avoidance of risk in their investments are key. They typically prefer guaranteed and highly liquid investments, like money markets, certificate of deposits (CDs), and U.S. treasuries.
Moderate investors are in the middle ground of risk tolerance and are willing and comfortable with accepting some risk to their principal. They generally adopt a balanced approach, investing a portion of their portfolio into a growth-geared fund that pays dividends and putting some money into less volatile options, like bonds or low- to no-risk securities.
Aggressive investors have a high risk tolerance and are willing to risk more of their money for the possibility of better/higher returns. This may include small company stocks considered highly risky because they can quickly lose value. Overall, the possibility of higher returns comes with the possibility of greater losses. Aggressive investors must accept this reality.
Risk Tolerance vs. Risk Capacity
Though they sound similar, these two concepts have a clear distinction: Risk tolerance is the degree of volatility an investor is willing to take in their portfolio, while risk capacity is the amount of risk an investor needs—or can afford—to take to meet their financial goals. Both concepts should be used to develop an appropriate individual financial plan.
Take risk seriously. Ignoring risk tolerance is a dangerous mistake to make. If you don’t know how you’ll react when the market—and value of your portfolio—drops, you’ll get a big wake-up call when it happens, perhaps causing you to sell low and flee the market. On the flip side, playing it too safe can prevent you from meeting your financial and retirement goals.
Managing risk often involves diversifying your portfolio—no matter your risk tolerance level. Diversification reduces the volatility in your portfolio because one asset’s loss can be mitigated by another asset’s gain. Working with a financial professional can offer some peace of mind that your assets are protected and in good hands. Financial professionals should focus on two key areas: protecting their clients’ wealth and principal and helping them meeting their financial goals. A healthy dose of education on investment risk will reduce the likelihood of panic selling and help manage your fears. Of course, there’s no true way to know how you will react if you lose money, but preparing yourself by being realistic about your risk tolerance can help mitigate your expectations and reaction and help you make the right decisions upfront and stay the course, rather than correcting later. Your retirement goals will thank you.
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