What is Risk Tolerance?
Risk tolerance is simply your ability to withstand fluctuations in the markets, which does mean the occasional loss.
The more risk tolerance you have, the less concerned you are with short term fluctuations. The converse is also true, the less risk tolerant you are, meaning you are risk averse, the less you are willing to lose money even in the short term.
Why is this important?
Depending on where you are in your investment life cycle, you may want to adjust your risk tolerance. For example, if you are young and just getting started investing, you likely will be more willing to take losses for the chance at higher gains. Young people typically don’t have as much to lose, and have time on their side to weather out any financial storms.
As you get older, and that nest egg grows in size, many people become less risk tolerant. This is especially true when you are getting closer to the age of retirement, when large swings in the stock market can drastically impact your financial fortress, when you need that money most. For more information on the impact of stock returns on your retirement, check out our article on sequence risk.
How do you play within your Risk Tolerance?
Your risk tolerance is a temperature gauge. There is no “right” temperature, but you’ll know it if you’re finding it too hot or too cold.
The good news is, if you find yourself in either of those situations, you can adjust through asset allocation.
In general, the heavier you are weighted in stocks, the riskier your portfolio is. Meaning the higher the upside, but also the higher the risk of incurring losses. If you would like to lower the temperature a bit, simply start adding in some fixed income investments, like bonds and cash. While the returns are lower, you’ll be better able to weather some turbulent financial markets.
The inverse is also true. If you’re disillusioned with your portfolio growth, start turning up the dial. Add in more equities into your portfolio. This will increase the risk, but also increase the potential for higher growth.
Pro tip: you can add in equities without pushing all your chips in. Adding in equities through a total market ETF will give you exposure to an entire index, while keeping the diversification of those separate companies. This will hedge off some of the risk of simply betting on a single (or select few) stocks.
How hot do you like it?
From 2010 to 2020, the stock market had been on one of the longest upward runs in history, especially in the United States. This likely influenced people’s self-evaluation of their risk tolerance. Seeing gains day after day for 10 years increased the FOMO (fear of missing out) of those prosperous times. It is quite easy to say you are “open” to the normal fluctuations when all you see is those double digit returns in the black.
The early part of 2020 was a reality check for many people. Years of positive returns were wiped out in an instant, with losses of well over 20% of total portfolio value.
This alerted people to the realities of investing in the short term; sometimes you win, sometimes you lose. And sometimes those wins and losses are big.
This is something you need to evaluate for yourself, taking into consideration your unique situation. Does the possibility of losses like that impact your ability to enjoy life? Do they cause an undue amount of stress? Or perhaps you were right in your assessment of your risk tolerance, and you aren’t fazed. Maybe you even recognize the tremendous opportunities that lie in crashing financial markets.
What to do if you’ve misjudged your Risk Tolerance?
Irrespective of the investing choices you may have made in the past, it is important that level heads prevail. If you think you were previously too risky, do not sell at a loss if you have any other options available. While nobody can tell how long the markets will be depressed, or even how low they will go, one thing is certain. We will survive. And, just as importantly, we will thrive again. What you can do going forward is change the asset mix that you invest in on a regular basis. By making an adjustment on your future contributions, you will over time change the asset allocation mix of your overall portfolio. This way you can learn from recent events, and avoid locking in any temporary losses.
Investing provides a way to make your money work for you. But it isn’t a guarantee that you will always like the outcome, especially in the short term. Understanding your risk tolerance will help you invest wisely, and sleep better at night.
A helpful guide to risk tolerance
While no one person is the same, a rule of thumb is often helpful to set some expectations for yourself. A formula to determine risk tolerance is:
115 - Age = Risk %
This estimates the amount of equities that you should have in your portfolio, based on your age. Understandably not every 30, 50, or even 70 year old is in the same situation. But the formula does help set your expectations. If you’re young and holding a conservative portfolio, you might be taking a lot off the table for the future you.
Think about your life, and your comfort level. Do your investments keep you up at night? Maybe a conservative play is better for your overall well-being. Or maybe the inverse is true. Only you can decide.
What is important here is that you decide. Make the choices today that are right for you now, and for you in the future. After all, it’s your future. The choices you make today will shape that future for you and your family.