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In a perfect world, every investment would net a return and you'd never lose any money. The problem is that real life is rarely that predictable. Investment losses are always possible, but so are gains—and sitting on the sidelines could mean missing out on future returns. Whether you're a high-stakes investor or more conservative with your money, it's possible to build an investment portfolio around your individual risk tolerance. Let's explore how risk tolerance works and, most important, how to determine yours.
What Is Risk Tolerance?
Your risk tolerance refers to the amount of financial risk you're comfortable taking when investing. Market volatility is unavoidable, and investment values are constantly in flux. This can be triggered by:
- Political news
- The strength of the economy
- Global crises including a war, a pandemic or supply chain issues
- Disruptions within certain industries
- Positive or negative earnings reports
The stock market is constantly moving up and down. You can turn a profit if you sell stock for more than you paid for it, and your earnings outweigh your tax liability. It's also possible to lose money. Your risk tolerance describes how much investment risk you can reasonably stomach. This can vary from one investor to the next. Some might be comfortable putting money into high-risk investments like hedge funds and private equity. Others might be more risk averse.
Why Is It Important for You to Understand Your Risk Tolerance Before You Start Investing?
Your investments and assets make up your financial portfolio. That can include stocks, bonds, real estate, businesses and more. Understanding your risk tolerance can help you create a portfolio that feels right for you. That means selecting investments and building an asset allocation that reflects your appetite for risk. A high-risk investor, for example, might devote a large chunk of their portfolio to funding startups or buying cryptocurrency.
Your age and financial goals can also impact the way you invest. If you're decades away from retirement, you may feel more comfortable with risk because you have time to recover from short-term market swings. But those who are retired or about to leave the workforce may play it safer. A conservative asset allocation might make more sense here.
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Types of Risk Tolerance
When it comes to investing, risk tolerance is a spectrum. Below are the three most common types, but you might see yourself somewhere in between. Risk tolerance can also evolve over time. That's what makes target-date funds so appealing. These age-based investment accounts automatically rebalance as you get closer to retirement. This way, your asset allocation will become gradually more conservative over time.
Aggressive Risk Tolerance
- Individual stocks
- Private equity
- Hedge funds
- Real estate
Riskier investments could translate to higher returns—or set the stage for major losses. Non-fungible tokens (NFTs) are a great example. Justin Bieber made headlines for allegedly spending about $1.3 million on a piece of digital artwork in early 2022. At the time of this writing, it's worth around $61,000. The value of cryptocurrency can also fluctuate wildly. Bitcoin skyrocketed to over $66,000 toward the end of 2021, then plummeted to about $16,000 a year later.
Medium Risk Tolerance
Investors in this camp crave a healthy mix of different assets. That's what diversification is all about, and it can help spread out the risk and offset your losses. If one part of your portfolio takes a hit, gains in other areas can help even things out. The 60/40 portfolio has long been a benchmark for investors with a medium risk tolerance. That means holding 60% stocks and 40% bonds. Between 2010 and 2020, the average annualized return for this type of portfolio was around 10%, according to investment research firm Morningstar.
Low Risk Tolerance
Even if you aren't keen on risk, it's important to maintain some exposure to the stock market. Otherwise, inflation could erode your wealth over time. That could lead to an inadequate nest egg when it comes time to retire. That's especially important for retirees who rely on money in tax-deferred retirement accounts like a 401(k) or traditional IRA. The IRS will take a cut of those withdrawals, but investment gains can help soften the tax blow. Retirees might opt for a 50/50 portfolio. There are also assets that can be used to conserve, rather than build, wealth. That includes bonds and annuities.
How to Determine Your Risk Tolerance
A financial advisor can help you determine the right risk tolerance for you. Asking yourself the following questions can also help clarify things:
- How many years do you have until retirement? You may be comfortable taking on more risk if you have a longer time horizon.
- What are you investing for? Aside from retirement, do you have any other specific investment goals? That may include buying a home or starting a business. If you're working toward a short-term financial goal, you might opt for low-risk investments to minimize potential losses. Investing in a high-yield savings account or money market account might make more sense than the stock market.
- How do you feel about risk? This comes down to your personality and how you navigate uncertainty. The general rule with investing is to ignore short-term volatility and stick to your investment plan, even during market slumps. Dumping your investments could mean missing out on a future recovery. Of course, nothing is ever guaranteed. Would you be able to handle significant losses along the way? Those who would rather have a smoother ride might have a lower risk tolerance.
The Bottom Line
Every investor is different. Some are comfortable wagering a large percentage of their wealth or investing in more volatile assets. For others, the financial unknown is territory they'd rather not explore. Many investors fall somewhere in the middle. Either way, you can create an investment portfolio that's in line with your risk tolerance.