How to Determine Your Level of Risk Tolerance

Determining your risk tolerance is crucial before you start investing. Read on to learn more about how to determine risk tolerance for investing and how you can use it to refine your portfolio. 

What is Risk Tolerance?

Before determining your unique risk tolerance, understand the general risk tolerance definition. Risk tolerance refers to an individual's willingness and ability to endure and accept the potential fluctuations or losses in the value of their investments. In exchange for accepting this risk, investors hope to see a higher capital return through stock price increase, dividends or another benefit. 

Determining risk tolerance is essential in investing for the future because the volatility you can withstand will vary depending on your financial goals. Assets that show less volatility and retain their value better in periods of economic downturn do not show the same level of growth during periods of economic prosperity. Investing in assets like penny stocks may result in more volatility, but it can also enhance returns if the investment is successful. 

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For example, municipal bonds will retain value exceptionally well during recessions and depressions because the government backs them. However, bonds will be left behind during booming periods, leaving profit on the table for investors in the form of opportunity costs. Determine risk tolerance before dividing your investment funds according to your value retention needs. 

Understanding Different Types of Risk Tolerance 

While there is no universal investment risk tolerance scale, we can examine a few general categories of investors. Most investors fall into one of the three categories when determining investing risk tolerance. 

Aggressive Risk Tolerance 

Investors with an aggressive risk tolerance are willing to take on a substantial investment risk in pursuit of higher potential returns. They typically have a long-term investment horizon and are comfortable with significant market volatility.

An example of an investor who could have an aggressive risk tolerance level is a young professional. Investors in their mid-20s will likely be investing for many years and thus able to handle a higher level of market volatility. Risk-tolerant investors may put more capital into volatile assets like growth-oriented stocks or investments in emerging markets.  

Moderate Risk Tolerance

Most investors fall into the "moderate" risk tolerance category, looking to balance growth during bull markets and retain as much value as possible during bear markets. Moderate investors often have a medium- to long-term investment horizon and may allocate their portfolio across a mix of equities, bonds and other asset classes.  

An example of an investor who may have a moderate risk tolerance is a worker in their 40s. While this investor will still likely be working for years before retirement, they may have other financial obligations (like a mortgage or a child's college education) that make market turbulence more challenging to withstand. These investors may use a retirement account like an IRA to invest heavily in diversified mutual funds or ETFs. 

Conservative Risk Tolerance

If you're approaching retirement, you may not be able to handle as much volatility as in the past. Investors with a conservative risk tolerance prioritize capital preservation and stability over higher potential returns. Conservative investors often have a short- to medium-term investment horizon and may allocate a significant portion of their portfolio to fixed-income securities, cash and less volatile assets.

An example of an investor who could take a conservative risk tolerance when building their portfolio is a senior in their early 60s. As these investors near the end of their careers, they will want to begin cashing out their investments, so growth is less of a concern. Their portfolio may have a higher concentration of bonds and other backed assets with insurance or guarantees to protect value. 

How to Determine Your Risk Tolerance

Learning how to measure risk tolerance starts with an examination of your personal financial goals and investing timeline. Take the following steps to determine your unique risk tolerance. 

Step 1: Learn about the major asset types. 

If you're a new investor, you might need to become more familiar with the multiple types of assets available. Stocks, bonds, ETFs and mutual funds are all investment vehicles with different levels of volatility, with each asset suitable for a different type of investor. 

MarketBeat's financial terms dictionary is an excellent resource for learning about common investment options. 

Image: MarketBeat offers a free financial terms dictionary with more than 200 in-depth definitions. 

Step 2: Consider your investment preferences.

Your investment preferences will play a significant role in the level of risk tolerance you'll need to accept. If your investing goal is to earn active income through trading, you'll likely need to invest in highly volatile assets to see a worthwhile potential return. On the other hand, if you're a long-term investor with an eye toward long-term retirement, you can achieve your financial goals without taking on more risk. 

Risk tolerance is about more than calculating return — you'll also want to consider your personal feelings and psychology when choosing an asset mix. If you have multiple investment portfolios already, you may be more successful in taking risks because you aren't jeopardizing your financial future when executing your trading strategy. Consider investment preferences, including how active a role you want to take in your portfolio management, when determining risk tolerance. 

Step 3: Create a list of financial goals and timelines.

Financial goals provide a clear time frame for investors to achieve specific objectives. Longer-term goals, such as retirement planning or funding a child's education, allow for a longer investment horizon. Investors with longer time horizons may have a greater capacity to tolerate short-term volatility and take on higher levels of investment risk to pursue higher returns. 

On the other hand, shorter-term goals, like purchasing a house in the next few years, necessitate a more conservative investment approach to preserve capital and ensure funds are available when needed. Create a list of financial goals and your timeline for each goal to determine the type of investments you can use to achieve them.

3 Questions to Help Assess Risk Tolerance 

After learning more about the market, it's time to take a closer look at your finances and investing timeline to refine risk. Be sure to ask yourself these three questions before creating your asset mix. 

How to Translate Risk Tolerance into an Investment Strategy

Once you know how much risk you're prepared to tolerate as an investor, you can use this information to create an investment strategy. Assets like stocks, bonds and ETFs all require investors to take on varying levels of risk in return for varying reward potential. Additionally, individual stocks and ETFs are considered safer than others, with blue-chip options retaining value better in times of volatility. 

Asset Allocation for Risk Tolerance

The most straightforward way to account for risk tolerance is to divide your investment capital between multiple categories of assets strategically. The three major assets most investors hold in their portfolios are stocks (shares of ownership in individual companies), bonds (a type of debt security issued by companies and government) and cash (fiat currency). ETFs, mutual funds and other investment vehicles are primarily made up of these three major assets. 

Stocks tend to have a higher risk and reward potential than bonds, which are riskier than holding cash. Diversifying your assets and adjusting your allocation over time will help you mitigate the inherent risks of participating in the stock market. 

The following is a sample allocation you might use when constructing a portfolio:

Changing Risk Tolerance and Asset Allocation

Risk tolerance is a dynamic characteristic, meaning your risk tolerance will likely change over time. If managing risk tolerance over the years sounds too complicated, know that many investment brokerages have created unique solutions to take management off the shoulders of individual investors. 

For example, the Vanguard Target Retirement 2050 Fund (NYSE: VFIFX) is an actively managed mutual fund aimed at investors who want to retire in the year 2050. Fund managers adjust the fund's asset allocation depending on how close investors in the fund are to retirement. Solutions like these can make managing the road to retirement easier for new investors. 

FAQs

The following are a few last-minute answers to questions about determining risk tolerance.