According to Investopedia, risk tolerance is the degree of uncertainty that an investor can handle in regard to a negative change in the value of his or her portfolio.  That is, how much of a loss would you be willing to endure in the short-term in exchange for higher potential returns?  Knowing your risk tolerance is vital if you intend to be a successful investor.  Investing at or below your ability to take risk makes it far more likely you’ll stick to your plan in bad markets and eventually reach your financial goals.  Taking too much risk only to panic and sell everything at the bottom of the market is a sure way to fail.

 Risk tolerance usually varies by age.  For example, young aggressive investors tend to be more tolerant of short-term fluctuations in the value of their investments because they have a long time horizon and have time to recover from short-term setbacks.  Older more conservative investors, however, often have low risk tolerances.  They may be in retirement and need to draw from their portfolio to cover day-to-day living expenses.  That is why peoples’ portfolios tend to become more conservative over time.

Determine Your Risk Tolerance 

There are four basic steps to determining your risk tolerance.  They are

• Determine your financial goals
• Assess your financial situation
• Determine your degree of comfort with risk
• Determine your need to take risk

 Determine Your Financial Goals

The first step in determining your tolerance for risk is to determine your financial goals.  The most common goal is retirement can be anything from saving for a child’s college tuition to a down-payment on a home to a new car fund.  The length of time until you need the money will be the main determinant in how the money is invested.  While some goals will be pretty concrete (the price of a new car in 5 years is fairly easy to estimate), others will not.  When you’re 25 years old and just starting out, you’ll likely have no idea how much you will need to be comfortable in 50 years.  And that’s okay.  Just do your best.  Even a vague idea that you’ll need $5 million to retire comfortably in 40 years is enough to get you started.

Assess Your Financial Situation

Before you can begin your investment plan, you should assess what you already have.  You may find you don’t need to take much risk at all to reach your goals.  For example, say your goal is to have $1 million for retirement when you turn 65 in 20 years.  If you already have $600,000 in your 401k, you would only need a 2.59% return on your money to reach that goal even if you never save another dime.  In this situation, your NEED to take risk is practically zero since you can probably get that return in low-risk treasury bills.  While you may be psychologically capable of taking on the additional risk of owning stocks, you really have no need to do so in order to reach your goals.  You may decide to avoid risk altogether. 

On the other hand, you may discover you are way behind in meeting your goal.  If you only had $50,000 saved in your 401k, you would need to earn 16.16% on your money every year to reach your goal of $1 million in 20 years.  In that situation, you may decide you need to take a significant amount of equity risk in addition to boosting your monthly savings to reach your goal.  If you invested 80% of your portfolio in stocks and saved $1000 per month, you would need to earn just over 9% per year to reach your goal, which is quite realistic.

Determine Your Degree of Comfort With Risk

This is where you determine just how aggressive you want your portfolio to be.  It’s easy to over-estimate your risk tolerance when you’re just starting out, so it is imperative that you be HONEST with yourself about how you would actually feel losing say, half your investment.  As a start, try this risk tolerance quiz.  It will give a general idea of how aggressive an investor you are based on a series of questions and hypothetical scenarios.

There are several useful rules of thumb, but my favorite is the max-loss rule.  It states that you should be prepared to accept a loss equalling half your equity allocation.  That is, if you have 90% of your portfolio in stocks, you should be willing to take a 45% loss.  And that’s not a theoretically number: depending on how you were invested, you could have easily lost 45% or more in the 2000-01 bear market.  If you can’t bear to lose that much money, investing 90% of your portfolio in equities is beyond your risk tolerance.

Determine Your Need To Take Risk

The concept of risk avoidance differentiates between your ability to take risk and your need to take risk are two very different things.  In the example above, suppose you had decided to invest 80% of your portfolio in stocks even though you only needed a 2.59% annual return to reach your goal.  While in all probability you would end up far exceeding $1 million, there is a chance, however small, you would lose money instead and retire in poverty.  Do you really want to take that chance?  Your risk tolerance is simply the MAXIMUM level of risk you are capable of taking.  But there is no reason you should invest for maximum risk when you don’t need to.  In this case, avoiding risk altogether is probably the wiser course of action.

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