Investing Explained: What Is Risk Tolerance?

All investing involves risk, but not all investments pose the same risk. Before diving in, take some time to explore your risk tolerance. Ask yourself how much risk you can (and want!) to take. 

Knowing where your ceiling lies (and when to move it) can inform your long-term plans … and outcomes. 

Here’s what to know. 

What is risk tolerance?

Your risk tolerance describes how much risk you can trade for potential investing gains. In other words, it’s your ability to handle investment swings. 

Some investors distinguish between risk tolerance and capacity, where:

• Risk tolerance characterizes your attitude toward risk. How you feel about possible losses, whether you stay calm when markets move, etc.
• Risk capacity relates to how much risk you can afford. The more money you make or have saved, the more risk you may be able to swallow. 

As you might expect, your emotional and financial tolerances lean on each other. Generally, the more loss you can afford while staying calm, the higher your tolerance. 

So, for our purposes, your risk tolerance describes the amount of risk you can handle financially and emotionally. 

Why does risk tolerance matter?

Risk tolerance plays an important role in your financial journey. Knowing how much risk you can take helps you determine:

• Which assets you buy and sell
• When you buy and sell them
• When it’s time to rebalance your asset allocation

Relying on feelings alone can lead to poor financial decisions. If you panic-sell stocks every time the market dips, you could lock in losses or miss long-term growth. If you can ride the ups and downs of the market without batting an eye, you might be able to weather more risk.

Finding the right balance can help you build a plan that’s solid, yet flexible enough for your needs, while letting you sleep at night. 

What factors into your risk tolerance?

Accurately gauging your risk tolerance can be tricky, especially since it’s not fixed. Your risk tolerance will evolve over time as life (and you) do. These factors can help you keep your finger on the pulse of it. 

Age

The math is simple. 

The younger you are, the more time you may have for the market to overcome short-term slides. (Though you may not want or be able to wait based on the next factors.) Many younger investors can take more risks now to chase potentially higher returns.  

Older investors usually have less time for the market to recover. These investors may prefer to trade less risk for smaller returns. 

Financial goals

Setting goals isn’t always about getting the most money the fastest. They’re about getting the money you need on a timeline you can stomach. 

You may find you’re willing to risk less to chase key goals like buying a house or sending your child to college. But for far-away or larger goals like retirement, you might accept more risk to seek higher rewards.  

Your general goals also matter. If you’re “just” seeking high growth or financial independence, you may chase higher risks. If you want to protect your existing assets or earn a stable income, you may set a lower risk tolerance. 

Time horizon

Your age, time horizon, and financial goals play well together. Younger investors with more time to reach their goals can usually afford more risk. But as you age closer to your goals, you may prefer to lower your risk to preserve your wealth. 

Your current financial situation 

Your financial situation dictates your risk capacity, which feeds into your tolerance. If you live paycheck to paycheck, it’s important to spend (or save) every dollar wisely. Higher-income or lower-expense households may have a higher risk capacity.  

Liquidity needs

How and when you need liquid (cash) money matter a lot. 

If you don’t have cash savings or an emergency fund, you probably have a lower risk tolerance. Otherwise, a sudden medical expense could force you to sell assets before you’re ready. (Maybe even at a loss.) And if your portfolio funds your living expenses, you likely have a lower tolerance than an investor just starting out. 

Your comfort level

Don’t discount the importance of your “pure” risk tolerance — your emotional state. The amount of risk you can afford may not match the amount of risk you can handle.

Balancing emotions and logic can be tough. You don’t want emotions to run your decision-making. However, you also don’t want to sell out every time the market drops 5%. Sometimes, a cautious approach makes sense to prevent you from panic-selling yourself into otherwise avoidable losses.

What is your risk tolerance?

Everyone lives a unique life, so everyone has a unique risk tolerance. However, most people live their uniqueness around a similar set of questions. It’s just the answers (and therefore your personal risk tolerance) that differ. 

What are your investment goals?

What are you saving and investing for? To retire? Buy a house? Send your kids (or yourself) to college? To take a once-in-a-lifetime vacation? 

How much money will you need to achieve these goals? Do you want to build wealth, generate income, or preserve your money? A mix of all three? Are you aiming “high” so you have wiggle room if the market underperforms?

When do you need the money?

What timeline are you saving for? The sooner you need the money, the less risk you may want to take:

• Short-term goals (5 years or less) usually have the lowest risk tolerances
• Medium-term goals (5-10 years) can usually handle moderate risk tolerances
• Long-term (10+ years) goals can usually handle the most risk

How do you react to paper losses?

It’s not uncommon for markets to move up and down rapidly. These “paper losses” can be scary. But! They don’t become “realized” (actual) losses unless you sell at a losing price. 

Investors with higher risk tolerances may be able to knuckle through to recovery (or profits) on the other side. But if paper losses make you panic-sell into realized losses, you may prefer lower-risk assets. 

How much investment experience do you have?

The more you know about a thing, the less you’re afraid of it. (Usually. Have you MET a spider??)

The same is often true of investing. Newer investors may have lower risk tolerances while they learn the market’s ins and outs. Over time, you may be willing to take more risk as you understand investing and assets in more detail. That’s okay! 

What’s your non-invested saving situation?

It’s important to keep some savings in safe, liquid accounts. For instance, high-yield savings accounts and certificates of deposit (CDs) offer insurance to protect your cash. 

In the event of an emergency, unexpected expenses, or the urge to splurge, you can access this cash without selling your assets. The more risk-averse you feel, the larger your savings (emergency, general, or goal-specific) may be. 

What’s your income?

Everyone can save and invest to build wealth. However, starting with a higher income or larger contributions means you have more money to grow. Consider:

• Whether your income can support your lifestyle AND your savings goals
• Your career prospects in the next 5-10 years
• If you need multiple income streams to accomplish your goals
• If (or how much) you rely on your income and/or investments to cover your expenses

The more wiggle room you have, the more risk you might be willing to stomach.

Risk tolerance strategies and examples

Risk tolerance is a spectrum that helps determine your investment strategies. Most investors fit somewhere into three primary categories:

• High-risk strategies (aggressive)
• Moderate-risk strategies 
• Low-risk strategies (conservative)

High risk tolerance portfolios

Aggressive investors prefer high risk tolerance portfolios. They’re comfortable riding out the market’s ups and downs in pursuit of larger rewards, despite the risk of larger or more frequent losses. 

High-risk tolerance portfolios may contain stocks, real estate, and alternative assets like commodities. They may also go for the riskier version of some assets, like small, volatile stocks instead of larger, more stable stocks. 

Moderate risk tolerance portfolios

Moderate investors prefer to balance some risk with some reward. They may not match returns with aggressive investors during outperforming markets. However, they may avoid massive losses when the market falls. 

Moderate risk tolerance portfolios, sometimes called “balanced” strategies, mix riskier and safer assets. These may include stocks, bonds, savings products like CDs, or Treasuries. One example is the 60/40 portfolio, which mixes 60% stocks and 40% bonds. 

Some moderate investors also keep a tiny slice of their portfolio in alternative assets. (Around 5% or less.) Others avoid these high-risk investments altogether. 

Low risk tolerance portfolios

Conservative investors take the least risk of all these strategies. Whether they’re aiming for slow growth, income, or capital preservation, their overarching priority is to avoid losses. Many are in or near retirement, though younger or newer investors may prefer less risk, too. 

Low-risk portfolios typically shy away from equities and other “high-risk, high-reward” assets. Instead, they maximize money market accounts, CDs, Treasuries, and high-yield savings.  

Keep your investments in line with your risk tolerance

Everyone’s risk tolerance is unique. That includes you! And as your risk tolerance changes, you may need to move money around to stay on track toward your goals. 

Using an app that can aggregate all your brokerage and retirement accounts — even across different financial institutions — can help you stay on top of everything at once, so you can see your mix of assets and the fluctuations of your portfolio’s overall value more clearly.