Risk Tolerance Definition
Risk tolerance is a measurement of the degree of variability in investment returns that an investor is willing to withstand. In other words, it measures an investor’s willingness or ability to handle investment losses and still achieve goals.
Why Is Risk Tolerance Important?
Knowing your risk tolerance is important when building a financial plan so that you can grow your money comfortably and avoid the stressors of investing beyond your means.
Lower-risk investments should be considered if you can’t afford or don’t want to risk losing any money (even temporarily), or if you would accept generally lower returns for the security of minimal losses.
Higher-risk investments may make sense if you can afford to lose some capital temporarily in hopes of gaining higher returns later on, or if you don’t need your money to be liquid for the duration of the investment.
Understanding risk tolerance helps you create an investment plan that works for you and your overall financial picture..
Risk Tolerance vs. Risk Appetite
Risk appetite is a broader term that refers to the levels of risk that are considered acceptable on a higher level. It is the general level of risk an organization accepts before deciding to take action to reduce the risk.
For example, your risk appetite regarding the purchase of new shoes could be described as what price you think you’ll have to pay for the shoes.
Risk tolerance is narrower and sets the acceptable level of variation around objects. It is the degree of variation from its risk appetite that you or an organization is willing to tolerate.
Using the shoe example from above, risk tolerance can be thought of as “How much above or below the amount that you thought you’d have to pay for new shoes are you actually willing to pay to still be happy with your purchase?”
How to Assess Your Risk Tolerance
The best time to assess risk tolerance is during a market downturn.
If the market is down and you feel the need to sell your investments, it’s likely that your risk tolerance is lower than you thought, whereas if you’re more inclined to buy additional investments when the market is bearish, you’re more likely to have a higher risk tolerance.
Types of Risk Tolerance
Conservative Risk Tolerance
Investments are solely focused on not losing capital. A conservative risk investment portfolio has a larger portion of low-risk, fixed income investments and a lower portion of high-risk stocks and funds that are likely to garner higher returns.
Moderate Risk Tolerance
A moderate risk investment portfolio can have both conservative and aggressive investments. It is traditionally a 60/40 split between stocks and bonds, where some capital is invested for growth, and some is invested for stability.
Aggressive Risk Tolerance
An aggressive risk tolerance portfolio has a majority of investments in volatile instruments that do not have a guaranteed return, like real estate and stocks. These types of investments, while not guaranteed to make a profit or return, generally have a higher return when they do. Generally, aggressive investors reach for maximum return with maximum risk.