Broker Check

Risk Tolerance: What is it? Why does it matter?

August 15, 2022
Originally published May 2020
Update August 2022

When I sit down to talk with new clients and prospective clients who are considering the decision to hire me, I often ask them about their "risk tolerance" or "risk appetite."

"Have you ever completed a Risk Tolerance questionnaire?" I ask.

More often than not, they shrug their shoulders and tell me they don't even know what Risk Tolerance means.

I'm never surprised at this, because there isn't exactly a class in high school or college that would explain the concept - yet we are all expected to save and invest for our future.

In the interest of helping you become a savvier investor, this month's post is all about your ability to tolerate risk and why it matters.

What is my Risk Tolerance?

An investor's Risk Tolerance is the level of fluctuation in investment results (return) that they can withstand before they consider selling their investments.

If you didn't know this already, investing in anything that isn't an FDIC-insured bank deposit carries some risk.

As the risk associated with an investment increases, so does its potential reward.

As the saying goes, "no pain, no gain." You can think of this as "no risk, no reward."

There is a spectrum of Risk Tolerance from Conservative (can't deal with any risk) to Aggressive (dial that risk to 11 please!).

Most investors fall somewhere in between.

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Asset Allocation

This whole concept of Risk Tolerance may be feeling a bit fuzzy, but stick with me.

We need to cover one more concept to make this more real: Asset Allocation.

Asset Allocation is the term we use to describe dividing money between different types of assets.

Those asset types typically include stocks, bonds, and cash.

Cash is the least risky, followed by bonds, and finally stocks (which are the riskiest).

As such, cash has the smallest potential return over time and stocks the biggest, with bonds somewhere in between.

How is this connected to Risk Tolerance?

An investor's Risk Tolerance should drive their Asset Allocation, which in turn drives the return they can expect to earn on average each year over the long term.

Why does it matter?

Your ability to tolerate risk is a key input in formulating both your Financial Plan and your Investment Portfolio.

Risk Tolerance dictates how much you need to save for your goals and how you should invest those savings.

If you can tolerate lots of risk, you can invest in riskier assets and will likely earn a higher return over time than a less risk tolerant investor.

Risk Tolerance is also a key factor in keeping yourself invested over time.

If you take on more risk than you can tolerate, there is a good chance you'll bail on your investments when markets get volatile (anyone considered bailing in the past several few months?).

Bailing out on your investments in a bad market can do major damage to your Financial Plan, setting you back months or even years.

Put simply, understanding Risk Tolerance is a foundational element of every client's Financial Plan and Investment Strategy.

Read: What Is Asset Allocation & Why Does It Matter?

Can you give me an example?

So far, our discussion has been rather abstract, so let's look at a specific example.

Mr. Wilson is a Conservative investor.

He is in his 80s with a portfolio of $2,000,000 and spends about $60,000 a year to fund his retirement lifestyle. He worries about losing or spending any of his $2,000,000.

So how should Mr. Wilson invest?

We know that he can't tolerate much risk, so owning stocks (quite risky) doesn't make much sense.

We also know that Mr. Wilson needs to make money to fund his lifestyle (since he wants to keep that $2,000,000 balance intact), so he shouldn't own only cash.

That means Mr. Wilson is an excellent candidate for a portfolio of mostly bonds (let's say 94%) and cash (the remaining 6%). Mr. Wilson will generally have two years' worth of the cash he needs at the bank, and the rest of his portfolio will generate interest income[1] he can use to fund his lifestyle in future years.

Because bonds carry less risk than stocks and don't change much in value over time, Mr. Wilson doesn't need to worry about much besides booking his flight to visit his grandkids over the summer.

What if Mr. Wilson gets a hot stock tip from his Pickleball buddy?

A can't miss, sure to triple by year-end, no-brainer of a stock tip. Mr. Wilson should ignore this tip and not buy the stock.

Sure, he may miss out on some return - but what if that can't-miss tip blows up?

What if Mr. Wilson uses $50,000 to buy some of this stock, and it promptly decreases in value by 50%?

As a Conservative investor, Mr. Wilson is likely to panic and sell the stock - like magic, he will have caused $25,000 to disappear into thin air.

Read: What Is Diversification? And How Do I Do It?

What about me?

It's likely that you don't necessarily relate to our Mr. Wilson, so I'll draw a more relevant picture.

Ms. Jones is a 30-something engineer who is just hitting her career stride.

Now that she's earning really good money, she feels ready to make her financial plan. She wonders, "How much do I need to save?"

Let's say Ms. Jones wants to have $2,000,000 in investable assets on the day she retires at age 65.

If her average annual rate of return is 10%, she needs to save about $12,000 each year until retirement.

If her average annual rate of return is 6%, she needs to save $25,000 each year until retirement. That's a pretty big difference in necessary savings.

Before she can determine how much to save, Ms. Jones needs to determine how much risk she can afford to take.

Too little risk, and she may not be able to meet her goals.

Too much risk, and she may end up making money vanish like poor Mr. Wilson.

Read: In Praise of Simplicity: Tips For a Healthy Portfolio

How do I know what my Risk Tolerance is?

Simple: You fill out a Risk Tolerance questionnaire like this one.

The six model portfolios on page 4 correspond to the hypothetical portfolios on page 2.

You can also interpret these six model portfolios as a continuum from Conservative to Moderate to Aggressive with the relevant shades of grey in between.

Once you know your Risk Tolerance, use it to guide your investment decisions.

It may be the cheapest insurance you can buy against mistakes your future self could potentially make.

Need guidance on what to own and how much to save?

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[1] This is a key feature of bonds.