How to determine your investing risk tolerance
Editorial staff, J.P. Morgan Wealth Management
- Risk tolerance may shape your investment approach. Whether you prefer a steady, predictable path or a high-risk, high-reward strategy, understanding your comfort level with market fluctuations may help guide your investment choices.
- Multiple factors influence risk tolerance. Your investment goals, time horizon, liquidity needs, age and experience all play a role in determining how much risk you can (and should) take on.
- Diversification may help balance risk and reward. A well-mixed portfolio of stocks, bonds and other assets can hedge against market volatility while potentially helping to position you for growth over time.
Does your ideal Sunday afternoon involve a calm walk around the block or zipping around hairpin turns in a sportscar? In either case, you’ll go on a journey – but one or the other might be a better fit for your personality and needs. Your risk tolerance is at the center of this preference.
In the same vein, your risk tolerance can help guide you toward the right types of investments for your goals and preferences by helping you determine whether you’d be better off with steady-moving investments or ones that give you a more intense ride. It’s also important to remember that your risk tolerance may change over time. While you may be willing to take greater risks when you’re younger, your risk tolerance may decrease over time.
But what is risk tolerance, and why does it matter for investors outside of this metaphor and in practice? Keep reading as we cover what investment risk tolerance is and how to figure out your own individual risk tolerance as you invest.
What is investment risk tolerance?
To start, let’s define risk tolerance and explain why the meaning of risk tolerance is something all investors should care about.
The official risk tolerance definition, per the U.S. Securities and Exchange Commission (SEC), is “an investor’s ability and willingness to lose some or all of an investment in exchange for greater potential returns.”
In short, risk tolerance is determining how much you’re willing to put on the line when you’re making your investment decisions.
How do you figure out your risk tolerance and why does it matter?
With investing, you typically face a trade-off: Investments that have the potential to return a lot usually involve more risk, which can give more turbulent rides, while investments with a lower rate of return may have less risk involved.
When you’re starting out, smoother, less volatile investments may not return enough to get you where you want to go. As you get older, choosing a smoother ride may provide greater assurance that you’ll make it to the finish line. Figuring out your risk tolerance is a way of working out which types of investments are best for you.
There are a few main factors that go into determining your risk tolerance:
Goals
What specific goals do you have for investing? Is it to buy a house or put away money for your children’s education? If your goals rely heavily on growth, you may need to take on more risk. However, if your primary goal is preserving wealth or liquidity, low-risk investments are likely a better fit.
Time horizon
This refers to how long you plan to hold your investments. If you need your money soon, like within the next three years, then you probably want to hold it in more stable investments because your portfolio might not have time to recover if the market stumbles.
If you’re investing for something that’s decades away, such as retirement, you may have the luxury of a longer time horizon. This allows you to take on more risk, as you’ll have time to rebound from market setbacks.
It’s important to note that your time horizon is likely to change, and you may need to reset how you think about this over time.
Liquidity (cash) needs
Liquidity refers to how accessible your money is when you need it. It may also reflect how much you can invest without affecting your overall quality of life. Investments like stocks and mutual funds are generally liquid, meaning they can be bought and sold relatively quickly. Real estate or certain retirement accounts, on the other hand, may require more time to access or may come with penalties for accessing them earlier rather than later.
If you anticipate needing quick access to cash or don’t have liquid capital available to hedge against losses, your risk tolerance may favor more liquid, low-risk investments.
Experience level
Finally, your familiarity and experience with investing may also influence your risk tolerance. Beginner investors may be more risk-averse and lean toward safer, low-risk options until they gain comfort and knowledge about the market.
Experienced investors, meanwhile, may feel more at ease navigating complex, high-risk investments.
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All investments come with different risks
Every investment faces a number of risks. With stocks, everything from natural disasters to new innovations can cause market fluctuations and volatility. With bonds, different economic environments and changing interest rates can send prices up or down.
Volatility is more nuanced than the broader market, too – two different stocks or two different bonds can have varied risk profiles. It’s incredibly important to make sure you understand all the risks before you invest.
One way to think about risk is in terms of “volatility” – a way of describing how bumpy your ride is likely to be with different investments.
More volatile investments tend to reach higher highs and lower lows, while less volatile investments typically don’t experience extremes.
Here’s how to think about the different asset classes and their risk profile:
- Cash: Cash gives you a gentle ride, like a leisurely walk, but it might not return enough to get you where you need to go. Also, it can lose value to inflation over time.
- Bonds: Bonds may provide a smoother ride than stocks, but they aren’t immune to market volatility. Like a bicycle, they may not move as quickly, and they can wobble, particularly in certain economic environments, and can also suffer losses.
- Stocks: Investing in stocks can be like riding in a jet. Stocks may go through some choppy ups and downs, but they can offer faster potential growth than the alternatives. Some stocks come with higher risks than others, too, which is another consideration to make.
- Funds: One way to balance risk and reward is with mutual funds and exchange-traded funds (ETFs), which may be made up of a combination of stocks and bonds or be tied to a performance of an index – like the S&P 500 – thus providing instant diversification and less inherent risk. It’s important to note that these investment vehicles still carry short-term and long-term risks.
- Real estate: Investing in real estate may be a way for investors to earn a steady income and hedge against stock market volatility, but geographic and economic factors can still drive volatility in the real estate market.
Now, how should you think about these asset classes as an investor? A diversified portfolio made up of a mix of stocks and bonds may offer better returns than bonds alone but with less turbulence than a portfolio of just stocks.
Many investors find this is in their comfort zone – like taking a drive in a sensible car. Still remember, diversification doesn’t guarantee a profit or protect against a loss.
Another element to consider when determining your risk tolerance is the difference between risk tolerance and risk capacity.
In short, risk tolerance refers to the emotional and psychological willingness to face uncertainties in your investments. For instance, how calmly can you handle seeing a 15% drop in your portfolio during a market downturn?
Risk capacity, on the other hand, is about financial ability. In other words, can you afford to take these risks based on your financial goals, resources and obligations?
Both are critical concepts to understand while you’re creating a sound investment strategy, so weigh them carefully.
Your portfolio should take on the amount of risk that’s right for you
Once you understand how much risk to take on, you can put together a portfolio.
Portfolio mixes may include:
- Bonds and cash or cash equivalents: Since these portfolios hold bonds and other investments that are seen as lower risk, they are expected to provide fairly steady rides. However it is important to note that these portfolios will likely have lower reward potential.
- Funds, individual stocks and bonds: With a mix of stocks and bonds, these portfolios could offer both growth and income with some stability. These may include mutual funds, index funds and blue-chip stocks that are seen as more reliable. With this type of portfolio, you’ll want to consider carefully whether you want to hold stocks or invest in diversified funds, as this choice can significantly impact your portfolio's risk, diversification and potential returns.
- Predominantly stocks and some bonds: Consisting of more stocks than bonds, these portfolios may offer greater long-term growth, but they also come with risks.
- Stocks and other high-risk, high-reward investments: These portfolios may consist primarily of stocks and other higher-risk, higher-reward investments. They might be right for you if you’re investing for a long-term goal and can financially handle an unpredictable ride.
The bottom line
Understanding (and respecting) your risk tolerance is a vital component of becoming a successful investor. It’s helpful when it comes to making rational investment decisions, staying on course through market fluctuations and ultimately reaching your financial goals.
Not sure how to assess your risk tolerance or build a portfolio? You don't have to go it alone. Talk to a financial advisor to create an investment strategy that’s just right for you.
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Editorial staff, J.P. Morgan Wealth Management
