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Risk tolerance is your ability and willingness to stomach a decline in the value of your investments. When you’re trying to determine your risk tolerance, ask yourself how comfortable you will feel maintaining your positions when the . There is an old Wall Street adage that says, “You can eat well or you can sleep well.” Eating well refers to the observation that over long time horizons, holding higher-risk assets (such as stocks) allows investors to accumulate significant wealth. However, that comes at a price, as , causing investors to lose sleep. Why risk tolerance is so important
Your risk tolerance plays a crucial role in your game plan for growing your money without stressing about it daily. If you don’t have the stomach for dealing with the risks of losing your principal, even temporarily, you’ll have to settle for and the lower returns that come with them. often come with a higher potential for sudden downdrafts or outright loss. With an understanding of your risk tolerance, you can create a strategy for your investments that will help you balance the worries of volatility with the potential for bigger returns when looking at the large picture. How risk tolerance works
Anyone can have a high risk tolerance when stocks are rising. However, the best time to truly assess your risk tolerance is when the market is falling. Think back to March 2020. The market tanked. Unemployment numbers soared. The world confronted an unprecedented level of uncertainty, . What was your risk tolerance then? Did you hang on through those tough times? If you sold stocks during the panic, your risk tolerance was low. Or were you willing to invest more to take advantage of the market sell-off? If so, your risk tolerance was high, and it has served you well as the stock market sets record-breaking numbers. Types of risk tolerance
There are a few different types of risk tolerance. Conservative risk tolerance
With this mindset, an investor is focused on preservation of capital and the avoidance of downside risk. That means lower returns, but the investor will settle for that in exchange for steering clear of any wild swings in value. For example, a is a very conservative investment. A bank or credit union will guarantee a certain rate of return in exchange for keeping an investor’s money locked away for a predetermined period of time. The promise of the return is a pro, but the low earning potential (CDs historically earn much lower than stocks and real estate) can be a drawback. An older investor who is closer to retirement will likely have a fairly conservative risk tolerance. Moderate risk tolerance
Moderate risk tolerance keeps a foot in two camps: conservative and aggressive. A classic example includes the traditional 60/40 allocation between and . This strikes a balance between some money invested for growth (stocks) while maintaining an eye on stability for income generation (bonds) at the same time. Aggressive risk tolerance
With an aggressive risk tolerance, the majority of an investor’s portfolio is allocated toward riskier assets such as stocks and . These offer the prospect of higher returns over time. That time component is a key ingredient, though. The investment has a greater chance of losing value in the interim, and there is no guarantee that an investor will actually get the money back. Being aggressive means being willing to accept the chance you will lose some or all of the principal. How to determine your risk tolerance
Determining your risk tolerance depends on answering a few key questions: What are your investment objectives? Are you investing regularly and looking to ? Or do you already have a decent nest egg and rather than grow it, are you looking to preserve it and live off of the income it generates? Each will convey a different tolerance for downside price risk. When do you need the money? Your time horizon is a crucial piece of the equation. The sooner you need the money, the lower your risk tolerance should be. Money you need for a next year has an entirely different time horizon than the that is still years away. How would you react if your portfolio lost 20 percent this year? Assessing your risk tolerance involves thinking about hypothetical challenges and worst-case scenarios. If your investment lost 20 percent of its value, would you lose sleep at night and pull out all of your funds? Or would you leave it invested and consider putting even more money in the market to capitalize on the discount? How investment experience relates to risk tolerance
What is your level of experience with investing? As you’re determining how much risk you can handle, it’s also important to think about how much knowledge you have of the investing landscape. It’s never been easier for anyone to and handpick stocks and other investments, but that level of convenience can also be very costly. Online chatter can create momentum around stocks and other investments that fuels uninformed buying and selling from inexperienced investors, making them vulnerable to sizable losses. So, be honest with yourself about your level of expertise. And as you start investing your money, be sure to invest your time in expanding your . Risk tolerance vs risk capacity
It’s important to assess your risk tolerance in relation to your capacity to take on risk. These two components should be aligned. For example, if you are a 20-something saving for retirement in your , you have a large risk capacity. You may have 45 or 50 years until retirement, which means you can afford to invest aggressively with the capacity to withstand the potential for a drop in value. However, your risk tolerance may not match up to that. You may be a nervous investor. Thinking about risk in the big picture
When you’re early in your career and , it’s important to have a long-term vision. It can be tough watching your investments decline from one day to the next. However, if you aren’t investing that money for tomorrow or next month, you have to recognize that it’s the end game that really counts. The stock market may , but it doesn’t deliver those 10 percent gains every year. Some years, it may be down more than 30 percent, whereas others, it might be up more than 30 percent. Measure the growth of your returns over time — not every single day. As you get closer to retirement, that’s when you will need to scrutinize your ability to deal with downside risks. Make sure that you are re-evaluating your risk tolerance and risk capacity to make the necessary adjustments. SHARE: Greg McBride, CFA, is Senior Vice President, Chief Financial Analyst, for Bankrate.com. He leads a team responsible for researching financial products, providing analysis, and advice on personal finance to a vast consumer audience. Lance Davis is the Vice President of Content for Bankrate. Lance leads a team responsible for creating educational content that guides people through the pivotal steps in their financial journey. Robert R. Johnson, Ph.D., CFA, CAIA, is a professor of finance at Creighton University and chairman and CEO of Economic Index Associates, LLC.