There are many extremely important terms for new investors to learn, but arguably none are more important than risk tolerance. Risk tolerance tells you everything you need to know about what kinds of investments are best for you and how to best weather financial storms.
What is risk tolerance?
Risk tolerance is exactly what it sounds like -- your ability to tolerate risk. In this case, it's about tolerating the risk of losing your assets or capital, a reality that every investor must face at some point. Even your savings account is at some level of risk (although it's extremely low).
When considering the types of investments you'll do best with, risk tolerance is everything. There's no point in investing in high-growth tech stocks if you won't get a wink of sleep with them in your portfolio. And there's no reason not to go for some if you feel secure about letting some grow and some go to zero.
Types of risk tolerance
Risk tolerance is roughly grouped into three categories:
High risk tolerance
People who can tolerate a lot of risk, often called aggressive investors, take big chances but also often see big payoffs. These people might choose a lot of start-ups with high growth potential, cryptocurrencies, or other highly risky assets because they can handle the emotional rollercoaster that comes with them.
Moderate risk tolerance
Many people fall into the moderate risk tolerance category. They can handle some risk, but they balance that risk with safety, so they know that if their risky assets fall through the floor, they will still be fine. They have moderate expectations, buy a variety of different asset classes, and may experiment with lots of different investment types.
Low risk tolerance
Investors with low risk tolerance can't afford or bear to lose much or any money. This isn't a flaw; it's often a function of a stage of life. Retirees, for example, can't really risk their nest eggs, as they have fewer opportunities to replace that money and should be very cautious. They might choose to invest in index funds, certificates of deposit (CDs), or large-cap stocks.
Some questions to assess risk tolerance
If you're unsure what your risk tolerance is, here are some questions to ask yourself:
- What is your time horizon? This is the most important question because you can easily make up losses over decades if you're young, but not so much if you're near retirement or already retired.
- Why are you investing? Your reason for investing is incredibly important and often informs your time horizon. Investing for retirement may allow for more risk than trying to increase the down payment you're saving for your first home.
- Can you handle a loss? This is where a lot of investors get it wrong. They want to be braver than they are, and as a result, they make serious mistakes with their investments. If the threat of loss sends you into a cold sweat -- or worse, a full-blown panic attack -- be honest with yourself. Even cautious investors can make money over time.
- How much money do you have in savings? Your savings account, although technically a type of investment, is a very safe place to keep your money. The more you have, the safer you'll feel about other risky investments that may have high returns.
- Can you stand not knowing? One thing that can help you tolerate more risk is to simply not look at your investment accounts more than a few times a year, particularly when you're buying new investments or evaluating their performance. If you can bear not knowing, you probably have a lot less anxiety about your investments than many people.
Why risk tolerance matters to investors
Risk tolerance is one of the most important concepts for any investor to understand. Not only does it inform what investments are best for you, but it can also help you better understand who you will be in a down market.
You don't want to be the guy who sells at the bottom simply because you can't stand how far a stock you were sure would do well has dropped due to external factors that ultimately don't affect the business enough to matter over the long term.
Related investing topics
Knowing yourself can also help you balance your investments. This allows you to dip your toe into riskier investments while still holding on to the proverbial dock of more secure investments, such as exchange-traded funds (ETFs) tied to major indexes.
For example, if you're a low risk-tolerant investor but want to get in on a new cryptocurrency offering, you may find that you can handle exposing 1% of your investable cash to that level of risk, so long as 50% of it is in bonds.
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