What role should risk tolerance play in your investing strategy?

It’s important for investors to assess their risk tolerance, and more importantly, realize they have control over how much risk they take on.

The U.S. stock market has performed very well since 2009, culminating in a record bull market run, but that doesn’t mean the good times are going to last forever. That’s why it’s important for investors to assess their risk tolerance, and more importantly, realize they have control over how much risk they take on. Remember that markets move up and down in cyclesOpens in a new window, but the historical trend is upward.

The first step in this process is to understand the difference between risk tolerance and risk capacity.

Risk tolerance

Your tolerance for risk is tied to your personality and how much you will worry about your investmentsFootnote 1. If you stress every time the market fluctuates, then you probably have a lower risk tolerance and would prefer investments that have a lower risk of losing money but offer lower return. Conversely, if you are willing and able to leave your money alone and stick to your long-term investment plan through difficult times in the market, then you would have a higher risk tolerance. You can also ask yourself whether you’ll need the money you are investing in the short-term, or how you would react if your investment dropped sharply in value.

Getting a handle on your risk tolerance can help prepare you to react appropriately to changes in the market and save you a lot of stress.

Risk capacity

At essence, risk capacity measures your ability to sustain financial losses if your investments go sour. If the stock markets took a significant downturn, those with higher risk capacities could stay the course and hopefully rebuild their assets over time. A lower risk capacity means you would be negatively affected in a major way should the market drop. For example, those nearing retirement probably wouldn’t want to stick a big chunk of their savings in a risky investment.

Risk tolerance comes down to your psychological makeup, whereas risk capacity is based on your real-world financial situation. It’s important for these two forms of risk to be aligned. If your risk tolerance is high but your risk capacity is low, you could run into real problems.

Planning your strategy

Once you determine your risk tolerance and your risk capacity, you can plan your strategy. As an investor, you’ll want to decide on either a conservative, moderate, or aggressive strategy for your portfolioFootenote 2. Typically, a more aggressive investing strategy would accept the likelihood of big swings in the value of your investment over time, but with a greater potential for higher returns. An aggressive strategy might feature mainly stocks (as opposed to bonds) from a mixture of big and small companies. At the other end of the spectrum, a conservative strategy might feature fewer stocks and a higher percentage of bonds, or money-market assets, which usually offer steadier returns with far less fluctuations in price. 

If you have a higher risk tolerance and higher risk capacity then you may be able to take a more aggressive strategy, while if your tolerance and capacity are lower, then you’ll likely need to be a more conservative. A moderate investor might be somewhere in the middle, perhaps someone with a higher risk tolerance but a lower risk capacity.

There are other factors that can impact how much risk you can handle. Your age plays a big role – the  younger you are, the more time you have to recover from market downturns. If you’re in your mid-20s and saving for a long-term goal like retirement, you might be able to handle short-term fluctuations in your investment. This is different from someone investing for a shorter-term goal like a vacation, where the most important consideration would be keeping your money safe. In the same manner, someone approaching retirement wouldn’t want to risk losing their nest egg, even if an investment promised higher returns.

Age is not the only factor. Someone who is recently married and planning to start a family might have to be more conservative when investing. Your life stage will always influence how much risk you can take on and your investment strategy should evolve.

There will always be risks involved in investing, but recognizing you have control over how much risk you take on should make you more comfortable. And remember, a financial advisor can help you tailor a custom plan to your specific situation.