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Why it's important to know your risk tolerance

For those who are specifically investing for retirement, determining risk tolerance often revolves around factors like:

  • Time until retirement
  • Desired income level in retirement
  • Anticipated expenses in retirement

Understanding these factors will help guide you towards or away from the investments you are considering.

It’s also worth noting that there is more to determining risk tolerance than financial ability. Some psychological or emotional factors can also influence your risk threshold. For example, loss aversion — the idea that losses cause greater pain than joy received from the same amount of gains — can play a major role in an investor's willingness to make risky investments.

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Risk tolerance vs. risk capacity

At first glance, risk tolerance and risk capacity might seem like interchangeable terms. But while they are related concepts, they actually refer to different things. Let's dig into what these terms mean.

Risk capacity

Risk capacity is your financial ability, objectively speaking, to be able to bear volatility and losses.

Your individual financial situation determines your risk capacity. In pursuit of your financial goals, how much risk are you able (rather than willing) to take on? Income, time frame, and rate of return are major factors in risk capacity. Lower income earners typically have a low risk capacity because it is more difficult to recover from an investment loss.

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Risk tolerance

Risk tolerance usually refers to your personal willingness to bear volatility and losses (though it is sometimes—including in this article—used broadly as a catch-all phrase for all risk).

How much money are you really willing (rather than able) to lose? What is your emotional capacity for risk? Risk tolerance is more about psychological fortitude rather than financial means. You may have excess capital to risk, but if you are particularly loss averse, you may be more inclined to hold onto losing positions.

How are these two concepts different?

Well, an investor might have the risk capacity to make certain investments, but not the risk tolerance to. For example, imagine a healthy 25-year-old receiving a high income from a steady job. He has a large emergency fund and his income exceeds his expenses every month. He probably has significant risk capacity.

Now imagine that he grew up in poverty and is in constant worry of not having enough money. This factor may lower his risk tolerance because he is unwilling to risk losing money, even though he can afford to.

Personal risk tolerance can complicate even the most objective risk capacity. And you should plan your financial goals with both in mind. Once your risk capacity and your risk tolerance are in alignment, you can begin to optimize your portfolio so that it targets your required return, while also giving you peace of mind.

More: Investment risk 101: everything you need to know before investing

What factors define your overall risk tolerance

As we’ve mentioned, financial risk tolerance is influenced by many factors. Anything in your life that affects your financial situation and emotional state could also have an impact on your appetite for risk. Having said that, here are some major factors to consider when assessing your own risk tolerance:

  • Age — Younger investors typically have a higher risk tolerance because they have more earning power, more time to realize gains, and more time to recover from losses. As you approach retirement, your investment strategy typically becomes more focused on investments that are safe or provide a fixed income.
  • Financial Goals — You should consider your financial goals when determining your risk tolerance. For example, if you need a 5% annual return to achieve your goals in retirement, you may decide you're not only willing to bear a level of volatility targets more than a 5% annual return.
  • Income — High income earners can swallow more volatility and losses due to having higher cash flow. However, if your monthly expenses exceed or approach your monthly income, a high income will count for much less when determining risk tolerance.
  • Dependents — Having children will typically lower risk tolerance due to the additional required resources to raise and care for them.
  • Debt — Debt will lower risk tolerance as these are financial obligations that usually increase your expense. It is often prudent to consider paying down high interest debt before investing.
  • Health — Some individuals are prone to surprise bouts of ill health, and others have serious medical conditions that may become worse. Risky investments may not be a wise choice if you don’t already have an emergency fund capable of covering surprise or long term medical expenses.

How does risk tolerance affect your investing strategy?

Understanding risk tolerance is a prerequisite for proper asset allocation. How will you allocate between stocks and bonds? Should you invest in an index fund that gives you broad market exposure? Or are you comfortable picking a handful of stocks that you believe in? All of these questions cannot be effectively answered until you have assessed your risk tolerance.

Your asset allocation and investment strategy should be built around your risk tolerance.

  • If you have a high risk tolerance…you might allocate a larger percentage of your investments in growth stocks to aggressively grow your portfolio.
  • If you have a lower risk tolerance.. you might allocate most of your portfolio to safer assets such as bonds.
  • And if you have an extremely low risk tolerance…you might have a larger portion of your assets in cash and cash equivalents. Cash and cash equivalents are often considered risk-free since they're usually federally-insured. But the downside of being too cautious is that inflation will devalue your money over time.

The above chart only takes stocks and bonds into consideration. But you can add other asset classes to your portfolio as well to further increase your diversification. Generally, the more risk-averse you are, the less of your portfolio that you should dedicate to alternative investments like cryptocurrency or real estate crowdfunding.

When is it a good time to evaluate your risk tolerance?

Any milestone or event in your life that impacts your financial circumstances warrants a reevaluation of your risk tolerance. Major events such as marriage, having children, a job change, a relocation, or receiving inheritance all warrant a review of your risk tolerance.

It's also important to consider that most retirees have a much lower earning capacity than they had during their working years. Therefore, they usually heavily rely on their investments, benefits, and pensions to cover their expenses. As you creep closer to retirement, you may have a lower risk tolerance.

This is the time that you might consider moving a larger portion of your portfolio to fixed-income investments to provide a steady stream of cash flow. You may also want to consider investing more heavily in dividend stocks. That being said, this is only a general rule of thumb. If a retiree owns multiple income-generating assets and has a spouse that's employed, the retiree may still have a high risk tolerance.

More: How to invest for retirement

How to design a portfolio around your risk tolerance

Growing a portfolio takes time, patience, and strategic thinking. Identifying your risk tolerance and quantifying your risk capacity are key to helping you determine your asset allocation.

Remember: your tolerance for risk should typically adjust as you get closer to your retirement or target withdrawal date. In most cases, you'll want to gradually increase the percentage of fixed-income assets (like bonds) in your portfolio. If you're looking for a more hands-off way to accomplish this, target-date funds will automatically make these adjustments for you as will robo advisors like Betterment and Wealthfront.

Determining your risk tolerance and knowing when to re-evaluate it will help you design a portfolio that's properly aligned to your personality and goals. To learn more about how to choose the right asset allocation for your risk tolerance, check out this guide.

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About the Author

Jay Wu, CFA

Jay Wu, CFA

Freelance Contributor

Jay Wu is a freelance contributor for Moneywise.

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