Risk Tolerance: What It Is and Why It Matters

Risk tolerance refers to how comfortable a person may be with investment uncertainty and changes in the value of their investments. It can be an important consideration when thinking about financial goals, investment choices and portfolio management.

What Is Risk Tolerance?

Risk tolerance describes an individual's willingness and comfort level when facing investment uncertainty. Some people may be comfortable with significant changes in investment values, while others may prefer less volatility.

Risk Tolerance Can Differ Between Individuals

Two people with similar incomes or financial goals may have different reactions to investment losses or market fluctuations. Personal preferences, previous experiences and financial circumstances can all influence risk tolerance.

There is no single level of risk tolerance that is appropriate for everyone.

Risk Tolerance and Risk Capacity

Risk tolerance and risk capacity are related but different concepts. Risk tolerance generally concerns a person's comfort with uncertainty, while risk capacity relates more closely to their financial ability to absorb potential losses or changes in investment value.

For example, a person may feel comfortable taking substantial investment risk but may have limited financial ability to absorb a large loss because of short-term financial obligations.

Factors That Can Influence Risk Tolerance

• Personal comfort with investment fluctuations.
• Previous investment experience.
• Financial goals and priorities.
• Investment time horizon.
• Income stability and financial obligations.
• Need for liquidity.
• Existing savings and investments.
• Ability to manage potential losses emotionally and financially.

Why Does Risk Tolerance Matter?

Investment decisions can become difficult when markets experience large movements. Understanding how a person may react to investment losses can be useful when considering an investment approach.

An approach that involves more risk than a person is prepared to handle may increase the likelihood of emotional or poorly timed decisions. However, reducing risk does not eliminate all financial uncertainty.

A Simple Example

Risk Tolerance and Investment Time Horizon

The amount of time before invested money may be needed can influence investment decisions. However, time horizon alone does not determine how much risk may be appropriate for a particular person.

Financial capacity, liquidity needs, goals and personal circumstances may also be important.

Risk Tolerance and Asset Allocation

Risk tolerance may influence how an investor thinks about asset allocation. Different types of investments can have different levels of volatility and potential risk.

However, diversification and asset allocation do not guarantee profits or prevent all losses.

Can Risk Tolerance Change?

Yes. A person's financial situation, goals and comfort level can change over time. Major life events, changes in income, approaching financial deadlines or investment experiences may affect how a person views risk.

Reviewing financial goals and investment approaches periodically may help identify whether previous assumptions are still relevant.

Common Mistakes to Avoid

• Assuming everyone should take the same level of investment risk.
• Confusing comfort with risk and financial ability to absorb losses.
• Ignoring the possibility of investment losses.
• Making decisions only because of short-term market movements.
• Ignoring liquidity needs and financial obligations.
• Failing to review investment decisions when circumstances change.

Key Takeaways

• Risk tolerance refers to comfort with investment uncertainty and fluctuations.
• Risk tolerance can differ significantly between individuals.
• Risk tolerance and risk capacity are related but different concepts.
• Financial goals, time horizon and liquidity needs can also affect investment decisions.
• No investment approach can completely eliminate financial risk.