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What Is Risk Tolerance – and How to Determine Yours

Key Takeaways

  • Risk tolerance is the amount of market fluctuation you’re comfortable withstanding in your investment returns.
  • There are two main factors involved with risk tolerance: risk capacity and willingness to take on risk.
  • Conservative portfolios have higher exposure to bonds; aggressive portfolios have higher exposure to stocks.

By nature, investing involves a certain level of risk. However, the level of risk investors take on varies from one person to the next.

Risk tolerance is the amount of fluctuation in the market you’re comfortable withstanding in your investment returns. Some investors choose aggressive portfolios that are prone to more substantial volatility; others prefer a more conservative approach with less ups and downs; and then there are those who are somewhere in the middle.

“Your risk tolerance is dynamic depending on your circumstances,” says Mike Cornacchioli, Senior Strategy Analyst, Citizens Bank Private Wealth Management. “There’s no simple way of approaching it.”

Meeting with a financial professional can help you identify your risk tolerance; so too can general risk tolerance questionnaires. However, you can begin to understand your risk tolerance by considering two factors: risk capacity and willingness to take on risk.

Risk capacity

Risk capacity is a good place to start when assessing your ideal exposure to risk. It measures how much you can withstand negative performance in your investments without jeopardizing your ability to reach your goal. Important factors include your age, time horizon, savings rate, income, and net worth.

“Simply put: If you have a longer investing horizon, you have more of a capacity to bear risk,” Cornacchioli says. “Time is probably the biggest ally for any investor.”

A longer investing horizon gives you the opportunity to overcome any losses prior to the target date of your goal. For example, if you’re planning for your retirement, you’ll likely have a lower capacity for risk if you’re two years away from retirement than if you’re only a few years into the workforce. (Note: Approaching retirement doesn’t necessarily mean you have to eliminate all risk since you’ll want to develop a retirement income strategy.)

Furthermore, as you approach your goal, take inventory of where your accounts stand. Are you ahead of your goal? You might consider dialing down your level of risk in order to cash out at the appropriate time. Are you behind? Perhaps you might consider taking on more risk or adjusting your target date.

The importance of the goal is another factor when evaluating your risk capacity. Is it a need or a want? You might be more apt to take on additional risk when investing for a vacation home than you would for your child’s education — there are no hard deadlines associated with owning vacation home, and you likely don’t want to have to worry about large fluctuations in performance as your child nears graduation.

Willingness to take on risk

The next factor to consider when evaluating your risk tolerance is far more subjective. Willingness considers how an investor would respond in a certain environment and how they feel about loss.

“If they’re not willing to take risk, they’re going to have a tough time being invested in an aggressive portfolio,” Cornacchioli says. “They may lose sleep over market fluctuations.”

Consider this example: You want to make a $100,000 investment and you’re trying to decide how much risk you want your funds to be exposed to. The following table shows the potential losses and gains associated with various levels of risk in a one-year period, from the most conservative (Portfolio A) to the most aggressive (Portfolio G).

*This chart is for reference only and is not an indication of expected performance.

During this hypothetical one-year period, Portfolio G could grow up to $149,000 or could fall to $76,000. On the other end of the spectrum, Portfolio A could grow to $110,000 but drop to $95,000. What potential gains and losses are you most comfortable with?

How conservative portfolios differ from aggressive ones

After you decide your risk tolerance, you’ll have to construct your portfolio (unless you’re using a robo-advisor) so your asset allocation properly reflects your intended level of risk.

Conservative portfolios tend to be more stable, predictable, and have fewer fluctuations, so they typically have higher mixes of fixed-income investments and bonds with some potential for diversification amongst the bonds. Some conservative portfolios might have a certain percentage of exposure to stocks to help diversify assets.

On the other end of the spectrum, aggressive portfolios are shooting for a higher rate of return with more fluctuations, so your assets would mostly be exposed to stocks.

As one might expect, moderate portfolios have close to 50:50 asset allocation between stocks and bonds.

Note: Portfolio managers and strategists have different methods when it comes to constructing conservative and aggressive portfolios. The same goes for robo-advisors, so make sure you consult your financial professional or research your digital investing platform to see how your asset allocation reflects your risk tolerance.

The bottom line

Your tolerance for risk is not a one-time assessment. As you approach your intended goal, it’s important to revisit your investment strategy to gauge whether you’ll have those funds available at the appropriate time. Otherwise, your exposure to risk could jeopardize when you reach your goal.

Furthermore, everyone has a different comfort level when it comes to risk. What works for one person might not be the appropriate strategy for the next, so it’s important to consider all the appropriate factors and consult with a professional when assessing your risk tolerance.

More information

Investing can be a helpful method of planning for the future, whether it’s your retirement or any other financial goal.  To learn how we can help you invest for the future, visit us online or schedule a Citizens Retirement Checkup at your nearest Citizens Bank branch.

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