What Is Risk Tolerance in Investing?
Risk tolerance is the amount of risk you’re willing to encounter when you start investing your money in the stock market or in other investment opportunities. It’s important to test and understand your tolerance for risk in the market so you can feel comfortable with the investment strategies and decisions you make. By understanding your personal tolerance for risk and investing, you can also be more realistic about how you expect your money to perform.
When you understand your risk tolerance, you can create a comprehensive investment strategy that includes details on how you invest your money, what you invest it in, and how long you expect to continue investing. A realistic confrontation of your investment strategy and the outcome you expect makes it easier to stick with your strategy and make decisions. While the risk tolerance you deal with is a personal decision, the amount of risk you tolerate should also be dependent on your age, goals, investment timeline, portfolio size, and the stage of life you’re currently in.
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Risk Tolerance Levels
There are specific risk tolerance levels you can identify with as an investor. Learning which risk tolerance level you identify with most is important so you feel in control of your investments and can maintain a positive attitude about the potential outcome.
Aggressive Risk Tolerance
Investors with aggressive risk tolerance are those who have a high tolerance for risky investments. If you have an aggressive risk tolerance, you’re willing to lose money or deal with a market decline momentarily to eventually make money.
Aggressive risk tolerance is best for investors who are looking at a long-term investment strategy and aren’t in need of current income. In the short-term, volatile investments may cause a loss in investment income, but investors with aggressive risk tolerance continue investing to eventually experience profit in the long term.
If you’re an investor with aggressive risk tolerance, you take chances and you may invest in stocks that could plummet quickly. You may also be more attracted to stock option contracts that can expire quickly with no value. While these risks are dicey, investors with aggressive risk tolerance can experience big payoffs if they choose the right strategies.
Moderate Risk Tolerance
You have moderate risk tolerance with your investments if you’re willing to accept a bit of risk in order to make a profit. Investors with a moderate risk tolerance take on investment strategies that may include some volatility but also envelop a more balanced approach that includes some less aggressive investments.
It’s common for investors with moderate risk tolerance to invest half of their investment portfolio into a growth fund that pays dividends. Moderate risk tolerance is best for investors who are following a long- or intermediate-term investment strategy and don’t need current income. Investors with moderate risk tolerance expect to eventually see some portfolio growth but aren’t necessarily following a strategy that will guarantee a big payout.
Conservative Risk Tolerance
Investors with conservative risk tolerance don’t invest in volatile stocks or other investments. They focus on an investment strategy that ensures they’ll maintain the original amount of their investments.
Investments that are guaranteed, such as certificates of deposit (CDs) or money market mutual funds, are more enticing for conservative risk investors. These investments are not associated with much risk, but they’re not highly liquid in the short term. CDs and mutual funds require investors to leave funds untouched for a certain period of time, else they incur a penalty in the form of taxation or a fee.
Conservative risk investors are usually those who anticipate needing income and financial stability. These investors are less focused on the growth of their investments and simply want to ensure they will have access to funds and don’t experience a loss of investment income.
Retirees or older investors are more likely to be in line with conservative risk tolerance investment strategies. Since they spent many years building their current wealth and they need income to live on, they’re less likely to want to risk it with potentially volatile investments.
Risk Tolerance Questionnaire
It’s important to determine the type of risk tolerance you have before you begin to implement an investment strategy. Not only do you want your investments to make money, but you also want to feel comfortable with how your money is performing.
If you embark on an investment strategy that’s too risky for your personal preference, you may panic and pull your money out before the funds have had time to fully mature and make a profit. This can ruin your investment strategy and cause you to lose money rather than grow it.
Consider completing a risk tolerance questionnaire to better understand your own acceptance level for investment risk. The Charles Schwab questionnaire is one resource you can use to find out more about your personal risk tolerance.
When you complete this questionnaire, you’ll need to answer questions about your knowledge of investments, how you prefer to invest money, and the current investments you have. The questionnaire also takes you through several investing scenarios to determine how you would react, which gives you insight on how tolerant you are with investment risks.
The number of points you receive for each question are added up and your score helps you to determine the type of risk tolerance you possess. If you have an aggressive investment tolerance, you may be encouraged to follow an investment strategy that includes about half of your investments in large-cap equity.
A moderate risk tolerance investor may want to follow an investment strategy that involves less large-cap equity investments and more of a balance with fixed income and international equity or other investments. A conservative risk investor’s strategy may involve about half fixed income and half cash investments, leaving little room for potentially volatile investments.
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