Understanding Risk Tolerance: What It Means for Your Investment Plan
- Mark Fonville, CFP®
- Mar 2
- 12 min read
Updated: Mar 11
Imagine you’re on a financial rollercoaster.
The ups and downs of the market can be exhilarating for some, but terrifying for others.
This is where understanding risk tolerance comes into play.
Risk tolerance is a crucial concept in investing that determines how much market volatility you can stomach without panicking or making rash decisions. It’s the financial equivalent of knowing whether you prefer a gentle merry-go-round or a heart-pounding thrill ride.
For investors over 50 with substantial assets, understanding risk tolerance is not just important—it’s essential. As you approach retirement, the stakes are higher, and the margin for error narrows. Your investment decisions now can significantly impact your financial future and lifestyle in retirement.
For instance, an aggressive investor, who has a high-risk tolerance, is prepared to lose money in pursuit of potentially higher returns and focuses primarily on capital appreciation.
But here’s the problem: many investors don’t truly understand their risk tolerance until they’re faced with a market downturn. By then, it might be too late. The panic selling that often follows can derail even the most carefully crafted investment plans, potentially jeopardizing years of savings and growth.
Assessing your financial circumstances is crucial when evaluating risk tolerance. Factors such as liquidity needs, time horizons, and the significance of financial goals in relation to overall well-being should be considered.
That’s why we’re diving deep into risk tolerance today. By the end of this article, you’ll have a clear understanding of what risk tolerance means for your investment plan and how to use this knowledge to make informed decisions that align with your financial goals and peace of mind.
Key Takeaways:
Risk tolerance is your ability and willingness to endure investment volatility
Your risk tolerance impacts asset allocation and investment decisions
Age, financial goals, and time horizon influence risk tolerance
Risk capacity differs from risk tolerance and should be considered
Regular reassessment of risk tolerance is crucial for effective investing, especially for individuals nearing retirement who needs to align their strategy with their financial goals
Professional guidance can help align investments with your risk profile
Balancing risk and return is essential for long-term financial success
All investments involve some degree of risk, which is crucial to understand for effective portfolio management
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What is Risk Tolerance?
Risk tolerance level is the degree of ups and downs in portfolio value that an investor is willing to withstand. It’s your ability to stay calm and stick to your investment strategy even when the market takes a nosedive. Think of it as your financial stress threshold—how much can you lose before you start losing sleep?
Understanding your risk tolerance level is crucial because it helps determine the appropriate mix of investments for your portfolio. A high risk tolerance might lead you to invest more heavily in stocks, which offer potentially higher returns but come with greater volatility. On the other hand, a low risk tolerance might steer you towards more conservative investments like bonds, which typically offer lower returns but with less price fluctuation.
An aggressive investor, characterized by a high-risk tolerance, often focuses on capital appreciation and is willing to endure significant market volatility in pursuit of higher returns.
Scott Hurt, CFP® at Covenant Wealth Advisors in Richmond, VA, explains, “Risk tolerance is not just about how much risk you can handle emotionally. It’s also about how much risk you need to take to achieve your financial goals. The key is finding the right balance between risk and potential reward that allows you to sleep at night while still working towards your objectives.”
It’s important to note that risk tolerance is not a fixed trait. It can change over time based on various factors, including your age, financial situation, and life experiences.
That’s why it’s crucial to reassess your risk tolerance level periodically, especially as you approach major life milestones like retirement.
Factors Influencing Risk Tolerance
Several factors can influence your risk tolerance:
Age: Generally, younger investors can afford to take on more risk because they have more time to recover from market downturns. As you get older and closer to retirement, you might become more conservative to protect your nest egg.
Financial Goals: Your objectives play a significant role in determining your risk tolerance. If you’re aiming for an aggressive financial goal, you might be willing to accept more risk, similar to an aggressive investor who focuses on capital appreciation. If capital preservation is your primary goal, you might lean towards a more conservative approach.
Time Horizon: The longer your investment timeline, the more risk you might be able to tolerate. If you don’t need the money for 20 years, you can potentially ride out market fluctuations.
Income and Net Worth: Your overall financial situation impacts your ability to take risks. If you have a stable, high income and substantial net worth, you might be more comfortable with riskier investments.
Investment Experience: Your past experiences with investing can shape your risk tolerance. If you’ve successfully navigated market downturns before, you might be more comfortable with risk.
Personality: Some people are naturally more risk-averse, while others are thrill-seekers. Your inherent personality traits can influence your approach to investment risk.
Pro Tip: When assessing your risk tolerance, consider both your willingness to take risks (emotional tolerance) and your ability to take risks (financial capacity). These two aspects don’t always align, and it’s important to find a balance between them.
Types of Risk Tolerance
Risk tolerance is typically categorized into three main types:
Conservative: Conservative investors prioritize preserving their capital over achieving high returns. They prefer stable, low-risk investments and are willing to accept lower potential returns in exchange for greater security. These investors might allocate a larger portion of their portfolio to bonds, certificates of deposit (CDs), and other fixed-income securities.
Moderate: Moderate investors seek a balance between risk and reward. They're willing to accept some market fluctuations in pursuit of higher returns but still want a level of stability in their portfolio. A moderate investor might have a mix of stocks and bonds, perhaps with a 60/40 or 50/50 split.
Aggressive: Aggressive investors are comfortable with high levels of risk in pursuit of potentially higher returns. They can often tolerate significant market volatility and may have a portfolio heavily weighted towards stocks, including growth stocks and potentially even speculative investments.
It's worth noting that these categories are not rigid, and many investors fall somewhere in between. Your risk tolerance might also vary for different portions of your portfolio.
For example, you might be more conservative with your retirement savings but more aggressive with a separate investment account earmarked for discretionary spending.
Risk Tolerance vs. Risk Capacity
While often used interchangeably, risk tolerance and risk capacity are distinct concepts that both play crucial roles in shaping your investment strategy.
Risk tolerance, as we’ve discussed, is your emotional and psychological ability to withstand investment losses. It’s about how you feel when your investments decline in value.
Your financial circumstances, including income and net worth, significantly influence your risk capacity.
Risk capacity, on the other hand, is your financial ability to endure losses. It’s determined by factors such as your investment time horizon, income, net worth, and financial goals. Risk capacity is objective and quantifiable, while risk tolerance is more subjective.
Andrew Casteel, CFP® at Covenant Wealth Advisors in Reston, VA, emphasizes the importance of this distinction: “Many investors focus solely on their risk tolerance, but understanding your risk capacity is equally crucial. You might feel comfortable with high-risk investments, but if a significant loss would jeopardize your ability to meet essential financial goals, your risk capacity might be lower than your tolerance. It’s our job as advisors to help clients find the right balance.”
Ideally, your investment strategy should align both your risk tolerance and risk capacity. If there’s a mismatch—for instance, if you have a high risk tolerance but a low risk capacity—it’s important to adjust your strategy accordingly to ensure you’re not taking on more risk than you can afford.
How Risk Tolerance Affects Your Investment Strategy
Your risk tolerance plays a pivotal role in shaping your investment plan. Here’s how:
Asset Allocation: Your risk tolerance largely determines how you divide your investments among different asset classes like stocks, bonds, and cash. A higher risk tolerance might lead to a portfolio with more higher risk assets like stocks, while a lower tolerance might result in a more balanced or bond-heavy approach1. An aggressive investor might allocate a larger portion of their portfolio to stocks, focusing on growth and capital appreciation.
Investment Selection: Within each asset class, your risk tolerance influences the specific investments you choose. For example, a risk-tolerant investor might opt for growth stocks or emerging market funds, while a more conservative investor might prefer blue-chip stocks or government bonds.
Rebalancing Frequency: Your risk tolerance can affect how often you rebalance your portfolio. Investors with lower risk tolerance might rebalance more frequently to maintain their desired asset allocation, while those with higher tolerance might be comfortable with less frequent adjustments.
Reaction to Market Volatility: Understanding your risk tolerance helps you prepare for and react appropriately to market fluctuations. This can prevent panic selling during downturns or excessive risk-taking during bull markets.
Retirement Planning: Your risk tolerance impacts how you save and invest for retirement. It influences decisions about when to shift to more conservative investments as you approach retirement age.
Pro Tip: While it’s important to invest according to your risk tolerance, don’t let it prevent you from taking necessary risks to meet your long-term financial goals. Sometimes, working with a financial advisor can help you find ways to manage your emotional response to risk while still pursuing appropriate investment strategies.
Assessing Your Risk Tolerance Level
Accurately assessing your risk tolerance is crucial for creating an effective investment strategy.
Here are some ways to gauge your risk tolerance:
Risk Tolerance Questionnaires: Many financial institutions and advisors use standardized questionnaires to assess risk tolerance. These typically include questions about your investment goals, time horizon, and how you’d react to various market scenarios.
Self-Assessment: Reflect on your past behavior during market downturns. Did you panic and sell, or did you stay the course? Your actual behavior can be a good indicator of your true risk tolerance.
Hypothetical Scenarios: Consider how you’d feel if your portfolio lost 10%, 20%, or 30% of its value. At what point would you feel compelled to make changes? Even better, turn those percentages into dollars. For example, if you have a $2 million portfolio, a 20% decline sounds a lot different than losing $400,000!
Financial Analysis: Look at your overall financial situation, including your income, expenses, assets, and liabilities. This can help determine your risk capacity, which should be considered alongside your risk tolerance.
Professional Assessment: A financial advisor can help you assess your risk tolerance more objectively and comprehensively. They can also help you understand how your risk tolerance aligns with your financial goals and risk capacity. Finally, you can develop an investing strategy that aligns with your risk tolerance and financial goals.
Remember, assessing risk tolerance isn’t a one-time event. It should be revisited periodically, especially after significant life changes or major market events.
Adjusting Your Portfolio Based on Risk Tolerance
Once you’ve assessed your risk tolerance, the next step is to align your investment portfolio accordingly. Here’s how you might adjust your portfolio based on different risk tolerance levels:
Conservative Risk Tolerance:
Higher allocation to bonds (e.g., 25-40% stocks, 75-60% bonds)
Focus on high-quality, investment-grade bonds and short-term bond maturities
Diversify across U.S and foreign markets
Consider removing emerging markets from your portfolio
Consider including cash or cash equivalents for stability
Moderate Risk Tolerance:
More balanced allocation (e.g., 40-65% stocks, 60-35% bonds)
Diversify across U.S and foreign markets
Consider adding some alternative investments for diversification
Aggressive Risk Tolerance:
Higher allocation to stocks (e.g., 65-100% stocks, 35-0% bonds)
Increase exposure to A rated and BBB rated bonds
Include higher weights toward value and small company stocks and potentially some speculative investments, as an aggressive investor focuses on capital appreciation and is willing to endure significant market volatility
Higher exposure to international and emerging markets
Consider more complex investment strategies or alternative investments
Remember, these are general guidelines. Your specific allocation should also consider factors like your age, financial goals, and overall financial situation.
The Role of a Financial Advisor in Managing Risk
While understanding your own risk tolerance is crucial, working with a financial advisor can provide valuable insights and expertise in managing investment risk.
Here’s how a financial advisor, like those at our firm, Covenant Wealth Advisors, can help:
Objective Assessment: Advisors can provide an unbiased assessment of your risk tolerance, often using professional tools and their experience with numerous clients.
Aligning Risk and Goals: They can help ensure your risk tolerance aligns with your financial goals and risk capacity, making adjustments where necessary.
Portfolio Construction: Advisors can build a diversified portfolio that matches your risk profile while still aiming to meet your financial objectives.
Ongoing Management: They can monitor your portfolio and make adjustments as market conditions or your personal circumstances change.
Emotional Support: During market volatility, advisors can provide perspective and help prevent emotional decisions that could harm your long-term financial health. They can help you understand the potential to risk losing money and manage your emotional response to market fluctuations.
Education: Advisors can help you understand different types of investment risks and strategies for managing them effectively.
FAQs
Q: Can my risk tolerance change over time?
A: Yes, risk tolerance can change due to factors like age, financial situation, or life experiences. It’s important to reassess your risk tolerance periodically, especially after significant life events or changes in your financial goals.
Q: What if my risk tolerance doesn’t match my financial goals?
A: If there’s a mismatch between your risk tolerance and financial goals, it’s crucial to find a balance. This might involve adjusting your goals, extending your time horizon, or finding investment strategies that can help you reach your goals within your comfort zone. A financial advisor can be particularly helpful in this situation.
Q: How often should I reassess my risk tolerance?
A: It’s generally a good idea to reassess your risk tolerance annually or whenever you experience significant life changes such as marriage, divorce, birth of a child, or approaching retirement. Major market events might also prompt a reassessment.
Q: Can I have different risk tolerances for different financial goals?
A: Absolutely. Your risk tolerance might vary depending on the specific goal and its time horizon. For example, you might have a higher risk tolerance for long-term retirement savings and a lower tolerance for shorter-term goals like saving for a home down payment.
Q: How does risk tolerance relate to asset allocation?
A: Risk tolerance is a key factor in determining your asset allocation. Generally, a higher risk tolerance allows for a higher allocation to stocks and other growth-oriented investments, while a lower risk tolerance might lead to a more conservative allocation with a higher percentage of bonds and cash equivalents.
Q: Do all investments involve risk?
A: Yes, all investments involve some degree of risk, which is crucial to understand for effective portfolio management.
Q: What is an aggressive investor?
A: An aggressive investor is someone with a high-risk tolerance who focuses on capital appreciation and is prepared to lose money in pursuit of potentially higher returns. They typically invest heavily in stocks and need to regularly assess their risk willingness and financial goals to align their investment strategy.
Conclusion
Understanding and accurately assessing your risk tolerance is a crucial step in creating an effective investment plan. It helps you strike the right balance between risk and potential return, allowing you to pursue your financial goals while still being able to sleep soundly at night.
Remember, risk tolerance is personal and can change over time. Regular reassessment and adjustment of your investment strategy is key to ensuring your portfolio continues to align with both your risk tolerance and your financial objectives.
While self-assessment can be a good starting point, working with a professional financial advisor can provide valuable insights and expertise in managing investment risk. They can help you navigate the complex interplay between risk tolerance, risk capacity, and your financial goals, ultimately helping you build a more robust and personalized investment strategy.
Aligning your investing strategy with your risk tolerance and financial goals is essential for long-term success.
Investing always involves some level of risk, but by understanding and respecting your risk tolerance, you can create an investment plan that works for you in both bull and bear markets. After all, the goal isn’t just to maximize returns—it’s to build a financial future that aligns with your values, goals, and peace of mind.
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About the author:
CEO and Senior Financial Advisor
Mark is the CEO of Covenant Wealth Advisors and a Senior Financial Advisor helping individuals age 50+ plan, invest, and enjoy retirement comfortably. Forbes nominated Mark as a Best-In-State Wealth Advisor* and he has been featured in the New York Times, Barron's, Forbes, and Kiplinger Magazine.
Disclosures: Covenant Wealth Advisors is a registered investment advisor with offices in Richmond, Reston, and Williamsburg, VA. Registration of an investment advisor does not imply a certain level of skill or training. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. The views and opinions expressed in this content are as of the date of the posting, are subject to change based on market and other conditions. This content contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Please note that nothing in this content should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax, or legal advice. If you would like accounting, tax, or legal advice, you should consult with your own accountants or attorneys regarding your individual circumstances and needs. This article was written and edited by a CERTIFIED FINANCIAL PLANNER™ professional with the assistance of AI. No advice may be rendered by Covenant Wealth Advisors unless a client service agreement is in place. Hypothetical examples are fictitious and are only used to illustrate a specific point of view. Diversification does not guarantee against risk of loss. While this guide attempts to be as comprehensive as possible but no article can cover all aspects of retirement planning. Be sure to consult an advisor for comprehensive advice.