Understanding Risk Tolerance

What if the market dropped 20% tomorrow? How would you react? Would you be able to stay calm, or would you panic?

Investing is all about balancing potential rewards with the risks you're willing to take. Staying calm during market swings is tough, but understanding your risk tolerance can help you stay the course and protect your long-term financial goals.

Let's explain risk tolerance and how it can guide your investment decisions.

What is Risk Tolerance?

Risk tolerance is your ability to handle swings in the value of your investments. In other words, it's how comfortable you are with the possibility of losing money in the short term in exchange for potentially greater long-term returns.

Here's a simple example:

The NASDAQ stock index has been one of the top performers historically, but it's no stranger to volatility. If you had invested $100,000 in the largest NASDAQ stocks at their peak in 2000 through the popular QQQ fund, your investment would have dropped to $30,000 just a year later. It would have been worth around $35,000 ten years later. In all, it took the index 16 years to recover its losses.

But what if you didn't sell? Today, your investment would be worth nearly $500,000. Great, right? But it depends. If you invested that $100,000 at age 30, you'd have seen significant gains by now. If you were 60? Watching your money shrink by more than half at a typical retirement age would be devastating.

That's why your time horizon - how long until you withdraw your money - is a key part of risk tolerance. But it's not the only factor.

Types of Risk Tolerance

Risk tolerance isn't one-size-fits-all. Investors usually fall into one of three categories: aggressive, moderate, or conservative. Let's take a look at what that means.

Aggressive

Aggressive investors are comfortable with high levels of risk and volatility in pursuit of maximum returns. They're willing to ride out big market swings and tend to invest heavily in stocks, especially growth stocks or other high-risk, high-reward assets. Typically, aggressive investors have a long investment horizon.

Sample aggressive portfolio:

• 80% stocks (a mix of growth stocks, small-cap stocks, and international equities)
• 15% bonds (to provide a small measure of stability)
• 5% alternative investments (like real estate or commodities)

This kind of portfolio is for those who can handle the ups and downs of the market, aiming for higher returns over the long term.

Moderate

Moderate investors are looking for a balance between risk and reward. They're okay with some level of risk for potential higher returns but aren't comfortable with extreme market swings. This approach gives room for growth while still maintaining stability during rough periods.

Sample moderate portfolio:

• 50% stocks (a mix of large-cap, mid-cap, and international stocks)
• 40% bonds (a diversified mix of bond types)
• 10% alternative investments or cash

This portfolio strikes a balance, helping you take advantage of market gains while providing protection against downturns.

Conservative

Conservative investors prioritize safety over growth. They're not comfortable with significant market volatility and prefer investments that offer stability and lower risk, even if it means smaller returns.

Sample conservative portfolio:

• 70% bonds (government, corporate, and municipal bonds)
• 20% stocks (blue-chip or dividend-paying stocks)
• 10% cash or cash equivalents (like money market funds)

This type of portfolio is designed to generate steady income and modest growth while minimizing the risk of loss.

Age and Risk Tolerance

Your risk tolerance isn't static. A 25-year-old is likely to invest differently than someone nearing retirement. The younger you are, the more time you have to recover from market dips, so most experts would suggest that younger investors can afford to be more aggressive. In comparison, those in their 40s or 50s might start shifting towards a more balanced portfolio with moderate risks. And finally, as an investor gets closer to needing their savings to pay for retirement, it might make sense to shift toward a more conservative approach.

This process, known as "de-risking," helps protect your investments based on your life stage and financial goals. The idea is to safeguard what you've earned so you don't have to worry about market crashes when you're ready to start using your savings.

Assessing Your Risk Tolerance

So, how do you figure out your risk tolerance? A few factors come into play:

• Time Horizon - How long before you need to access your savings? As our NASDAQ example illustrates, the longer your investment horizon, the more risk you can afford to take (though there are no guarantees, no matter your time horizon).
• Income and Net Worth - The more financial security you have, the more comfortable you might be with taking on risk. Higher-income investors might be able to take more risks with a portion of their portfolio.
• Emotional Comfort with Risk - Let's face it: market swings aren't fun. If the idea of losing money (even temporarily) gives you sleepless nights, it's worth considering whether that stress is ultimately worth it to you.

Remember, risk tolerance can change over time. Major life events like getting married, having kids, or even switching careers can impact your financial goals and, consequently, how much risk you're willing to take.

Portfolio Reviews and Market Fluctuations

Regular portfolio reviews allow you to assess whether your current investment strategy aligns with your risk tolerance and objectives. Over time, markets can push your portfolio away from its intended mix, making it more aggressive or more conservative than you might like. Rebalancing - shifting funds between stocks and bonds, for example - can help keep your risk level in check with your goals.

Here's one scenario: after a strong stock market performance, your portfolio may be "overweight" in stocks, meaning a larger percentage is invested in stocks than you intended. That could increase your risk exposure without you realizing it. By selling some of those stocks and reinvesting in bonds or other stable assets, you can bring your portfolio back into balance and maintain your intended asset allocation.

But...

One of the biggest challenges in investing is staying calm during market downturns. When your portfolio takes a hit, the temptation to sell is strong, but reacting out of fear can do more harm than good. A well-planned portfolio, based on your risk tolerance, should be built to weather these storms.

Focusing on long-term goals rather than short-term market fluctuations can help you stay the course. Markets have historically recovered from downturns, and a diversified portfolio has the potential to grow even after periods of decline (remember our NASDAQ example?).

One strategy to stay disciplined is dollar-cost averaging, where you invest a fixed amount regularly, no matter what the market's doing. This way, you reduce the impact of market fluctuations, and when prices dip, you're buying at a "discount." But remember, this approach is best for diversified investments like index funds, not single stocks, which carry higher risk. Doubling down on a single stock is significantly riskier since it can lose all of its value!

The Takeaway

Understanding your risk tolerance is crucial for building a portfolio that works for you. Whether you're aggressive, moderate, or conservative, the key is to create a diversified portfolio that reflects your comfort with risk, review it regularly, and stick with your strategy - even when the market gets rocky.

And remember, we've only scratched the surface here. For advice tailored to your situation, talk to a financial professional who can help you make the best decisions for your future.