How to Determine Your Investment Risk Tolerance

You don’t need to be an economist to understand risk tolerance. Every investor has an appetite for a certain level of risk. Some don’t mind taking a chance on high-risk/high-reward stocks or alternatives. Others are more risk-averse and want safer investments like bonds and mutual funds. Some investors fall somewhere in the middle.

Here are some examples of different risk tolerances:

• Conservative Risk Tolerance
  Those with a strong aversion to risk tend to broadly fall in the conservative category. Their portfolios are more heavily weighted with low-risk investments like bonds, mutual funds, and cash equivalents.¹
• Moderate Risk Tolerance
  This category is for investors who don’t mind taking some risk but want to have a few safe investments to fall back on. Moderate investors may create a portfolio that includes both stocks and bonds that may have a 50/50 or 60/40 structure.²
• Aggressive Risk Tolerance
  Investors willing to take big risks for potentially higher returns have an aggressive risk tolerance. These investors may be more likely to invest in initial public offerings (IPOs), venture capital, real estate investment trusts (REITs), or penny stocks.³

A risk tolerance assessment is a process that can help an investor to determine their comfort level when investing.

We’ve put together a brief version of a risk assessment here that you can use to get an idea about how comfortable you are with risk:

1. What Are Your Investment Goals?
   Outline your big-picture goals. Retirement plans are investment funds that have an obvious goal. An investment portfolio, self-managed or managed by a financial advisor, could have another purpose. Two examples are using the funds to buy a second home or helping to helping your children to pay for college someday.
2. What Is Your Timeline Like?
   Timeline is a big factor in risk assessment. Investors with a longer timeline, like those who start investing in their twenties or thirties, may have time to recover from market losses. Investors nearing retirement age, on the other hand, may need to be more conservative because they have less time before they’ll need to start withdrawing from investment accounts.
3. How Do You Feel About Short-Term Losses?
   Assess how you feel about losing money, even for a short time. Loss aversion affects people in different ways. Behavioral economics describes it as a condition where the fear of loss is more intense than the joy of an equivalent gain.⁴ A strong aversion to loss puts you in the “conservative” investor category.
4. Are You Planning to Track Your Investments Regularly?
   A common school of thought is that investors who check their portfolios more often have a lower risk tolerance. That might be true for a passive investor with a financial advisor managing their money, but not for an active investor managing their own portfolio. If you’re the latter, you probably have a higher risk tolerance.

Aligning your investment choices with your risk tolerance can optimize returns while mitigating potential losses. Keep in mind that portfolio performance can also be affected by shifts in the global economy, inflation, and government or industry regulations. You have no control over these factors, but risk and return analysis can improve your odds of success.

Taking a greater risk may sometimes result in a potentially larger return, but it carries a greater chance of loss. Choosing conservative investments might mitigate losses, but your returns might be lower. Finding a balance between the two is a goal many investors share. One way to balance risk and return is by allocating your investments into “buckets,” each with separate goals. For example, you could have a bucket that’s created for income, where you take a more aggressive approach. You could have another bucket that’s used as an emergency fund, which you invest more conservatively.

Another strategy is to diversify your portfolio and invest in a balance of stocks, bonds, cash equivalents, and alternative investments.⁵ Combining assets that have different risk factors allows you to match your portfolio with your risk tolerance. Rebalance monthly or quarterly to ensure you maintain that risk target. Change it if your goals change.

Investors should also look for other ways that they can help to mitigate potential losses. For example, consider stock trading, which is a high-risk investment. However, you can take measures to mitigate loss by looking to implement stop-loss orders, which instruct a broker to buy or sell a stock once it reaches a certain price point. When implemented correctly, this measure could help to reduce potential loss.

Another example of taking steps to reduce risk is asymmetric investing, which involves assessing the risk and reward of a potential investment and determining that the probability of a trade has more profit than loss or risk.