Understanding risk tolerance and how it impacts your investment strategy

By Jamie Viceconte, Investment Product Head | Citizens Wealth Management

"No risk, no reward" applies to both everyday life and investing. In general, pursuing higher potential returns requires accepting a higher level of risk. As an investor, the key is to find the right balance of the two — understanding your risk tolerance is a foundational step in that process.

When your portfolio is built around your goals, current financial situation and comfort with volatility, it becomes easier to maintain a long-term perspective, even during periods of market uncertainty.

What is risk tolerance?

Risk tolerance refers to your psychological level of comfort with fluctuations in the value of your investments. Because risk and return are closely linked, understanding this threshold is key to building a portfolio that's appropriate for you.

Markets don’t typically move upward in a straight line. Periods of growth are often accompanied by periods of decline, and short-term volatility is a natural part of long-term investing. Risk tolerance reflects how comfortable you are experiencing these types of market movements.

Your risk tolerance is often determined using questionnaires, assessments or through conversations with a financial professional. For example, how would you respond to a 10% decline in your portfolio over a six-month period?

• Investors with higher risk tolerance may prefer aggressive portfolios with greater exposure to equities and higher growth potential, along with greater variability.
• Investors with lower risk tolerance may favor more conservative allocations with less volatility.
• Many investors fall somewhere in between, opting for a balanced mix of assets.

Aligning your portfolio with your risk tolerance can help you feel comfortable with your investments and stay focused on long-term goals.

Risk tolerance vs. risk capacity

Risk tolerance and risk capacity are closely related, but distinct. While risk tolerance is based on your emotional comfort with market volatility, risk capacity is defined by your financial ability to take on risk without jeopardizing your financial goals.

Risk capacity is influenced by objective factors such as your time horizon, income, net worth and spending needs. Financial professionals may use tools such as cash flow analysis and scenario planning to help assess it.

The importance of time horizon

Time horizon is one of the most important factors in determining risk capacity. In general, a longer time horizon allows for greater exposure to market risk, since there is more time to recover from short-term declines. When determining your time horizon for your goals, consider these three buckets:

• Long-term goals: For objectives such as saving for a retirement that is decades away, a greater allocation to growth-oriented assets may help improve the probability of achieving your goals.
• Intermediate goals: Funds you need to access in five to ten years may require a balance between growth and stability.
• Short-term goals: Assets intended for near-term use are often better held in lower-volatility, liquid savings vehicles.

Your financial goals and time horizon are key to determining the right amount of exposure to risk. Taking too little risk for long-term goals can be as limiting as taking too much risk for short-term needs.

How risk tolerance shapes portfolio construction

Risk tolerance and risk capacity should both inform your investment strategy. This is expressed through asset allocation: the mix of equities, fixed income and cash within a diversified portfolio. In general, these assets serve the following purposes:

• Equities: Higher growth potential, with greater volatility.
• Fixed income: Lower volatility, with more moderate return expectations.
• Cash and equivalents: Stability and liquidity, with lower return potential.

Most portfolios incorporate all three asset classes, with allocations tailored to individual goals and risk profiles. For example, an investor with a high risk capacity may be financially positioned for a more aggressive, equity-heavy portfolio. However, if their risk tolerance is low, they may opt for a more balanced allocation of equities and fixed income to help reduce volatility while still supporting long-term growth.

Why risk tolerance changes over time

Risk tolerance is not static. It can change as your financial situation and life stage evolve.

An investor with a high income and no major debt may have a higher risk tolerance while planning for a retirement that is 30 years away. However, as that investor approaches retirement and their savings target, preserving assets and generating income becomes a greater priority. This reduces the need to take on investment risk and often translates into a lower risk tolerance.

That's why it's important to periodically reassess your portfolio at regular intervals to ensure that it reflects your current goals and intended level of risk.

Finding the right balance for your portfolio

Your risk tolerance is a key part of building an investment strategy that aligns with your goals. It helps guide how your portfolio is structured, and how it may adapt as your needs and market conditions change over time.

While investing involves navigating both risk and uncertainty, a trusted partner can make all the difference. A Citizens Wealth Advisor can help you assess your risk tolerance, recommend a portfolio tailored to your goals and move forward with confidence.

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