Do you like to throw caution to the wind? Roll the dice and take a chance? Or would you rather...
Published April 23, 20218 min read
Do you like to throw caution to the wind? Roll the dice and take a chance? Or would you rather carefully consider all your options and choose the safest path? Or something in between? How you answer these questions will give you a sense of what your risk tolerance is. And when it comes to creating an investment plan, understanding your risk tolerance is an important part of the process.
Your risk tolerance is how willing you are to lose money when you make an investment. Generally, the higher the risk level of an investment, the greater the potential return. But also, the greater the potential loss. No one wants to lose money, but all investing involves that risk. Your tolerance is measured by how willing you are to embrace that risk.
Your risk tolerance will be influenced by a number of a factors including, your age, income level, financial condition, and your personal comfort level. Each person is different. Two people might have similar make-ups on all of these factors except for personal comfort with risk and could have different risk tolerances.
Your risk tolerance could also change over time. For example, as people get older, they tend to become more risk adverse. Or, as they make more money, they might develop a bigger appetite for risk. Risk tolerance isn’t static. It changes as your life circumstances change. Let’s take a closer look at the individual factors that influence your risk tolerance.
The younger you are, the greater your risk appetite is likely to be. The main reason for this is that you have a longer time horizon, meaning you have more time to potentially make up any losses you might experience. As you grow older, your risk appetite is likely to decline. A person on the cusp of retirement will likely have much less appetite for risk than someone in their 30’s.
The more money you make, the greater your ability to absorb losses (although not necessarily your willingness to do so), and a factor in this is also potential income. For example, if you’re a doctor, your income will increase as you transition from being a resident to an attending physician and should increase as your career progresses. It’s likely that as your income increases, so will your ability to cover your basic needs, leaving you more money to invest, as well as a greater ability to absorb losses.
The state of your finances will also impact your risk tolerance. If you have high debt levels, you’ll probably be less willing to take on a lot of investment risk until you’ve managed to bring your debt balances down. The stronger your financial condition, the less impact investment losses may have on you.
The biggest factor affecting your risk tolerance is you. No one likes to lose money. But some people really, really hate to lose money, so much so that they’re willing to accept minimal returns in favor of safety. Others are more willing to accept higher risk in the pursuit of higher returns. And no matter where you fall on any of the above factors, your aversion to losing money may very well overrule them all. Where do you fall? There’s no right answer. You have to figure out your own comfort level.
|Risk Level||Avg Annual Return||Biggest Gain||Biggest Loss||# of Losing Years|
|Low (30% Stocks/ 70% Bonds)||7.7%||+38.3%||–14.2%||18|
|Moderate (60% Stocks/40% Bonds)||9.1%||+36.7%||–26.6%||22|
|High (80% Stocks/20% Bonds)||9.8%||+45.4%||–34.9%||24|
|Aggressive (100% Stocks)||10.3%||+54.2%||–43.1%||25|
When you look at the table above, what numbers are your eyes naturally drawn to? The average returns? Biggest gains? Biggest losses? Does the idea of earning over 54% in one year excite you? Or does the idea of losing over 43% terrify you? The number you linger on will give you a clue about your risk tolerance. And you can explore this further by asking yourself: How would you feel about earning a 7.7% annual return (the lowest above) at the risk of losing just over 10% in a given year vs. the chance to earn a higher return with a moderate risk portfolio but also at the risk of a bigger potential loss in any given year?
The higher the return potential, the greater the risk involved. As you slide up that curve, where is your sweet spot? Keep in mind that the difference in a 1% return can add up to thousands of dollars over a long period of time. Take a portfolio where you start with $100,000 and contribute $40,000 each year for 20 years. If you earn an 8% return on that portfolio, you’ll have $2.3 million after 20 years. But if you earn a 9% return, you’ll have $2.6 million after 20 years. A difference of $300,000! But you’ll also likely be exposed to more risk with a portfolio that earns an average of 9% annually. There will probably be more losing years, and years where the losses will probably be higher than they would be if you had a portfolio that earned 8% annually. How does that sit with you?
You can get a sense of what your risk tolerance is by trying on these different scenarios for size and seeing how they feel – remember, your risk tolerance is your willingness to lose money in the pursuit of investment returns. This is all about your comfort level. And the other factors such as age, income and financial condition all influence your comfort level. Once you get a sense of where you are on the risk spectrum, you can begin to think about what your ideal investment portfolio will look like.
While you’re thinking about your portfolio, keep in mind that risk tolerance is different than risk capacity. The former is your willingness to take risk. The latter is the risk you must take in order to achieve your financial goals. For example, you might not be willing to invest in technology stocks because you find them too volatile. However, you might have to invest in technology stocks in order to realize a rate of return that will get you to your financial goals. If there is a conflict between your tolerance and your capacity, tolerance will win. However, that will also mean you will have to make adjustments elsewhere in your investment plan in order to be able to achieve your investment goals.
Figuring out your risk tolerance involves a little bit of self-analysis. Your age, financial condition, income level, and general personal comfort will all play a role in what you’re comfortable with, but ultimately, you have to make the call on what you’re willing to lose in the pursuit of investment returns. Remember: nothing ventured, nothing gained!
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