Understanding risk tolerance: What it is and why it matters for investors

My son loves roller coasters. At 15, he saved his lawn-mowing money for months to fund a trip to Cedar Point in Sandusky, Ohio — the roller coaster capital of the world. For him, the appeal stems from that combination of fear and excitement, the funny feeling you get in the pit of your stomach as the coaster climbs into the sky.

It doesn't feel like a stretch to say that the stock market is my version of a roller coaster: ups, downs, excitement, and a little fear. There was a time I shared my son's thrill-seeking drive, but these days, my risk tolerance is less risky. And while I find stocks a valuable tool in helping me achieve my financial goals, I know it's most rewarding when I invest according to my risk tolerance.

Stay with me, and I'll explain what I mean.

What is risk tolerance?

Risk tolerance is a measure of a person's comfort level with the possibility of their account balances decreasing over any given period of time. It can also be described as their emotional limit, or their willingness to take on a certain level of risk.

Risk tolerance is one of the most important components of any investment strategy because it determines the mix of stocks, bonds and cash in the investor's portfolio.

In general, cash is seen as less risky than bonds, which are less risky than stocks. That's not always the case, but it's a good rule of thumb when looking at broad categories.

How risk tolerance levels are measured

Risk tolerance is often defined on a scale. On one end, you have “preservation of capital,” which is just a fancy way of saying “I want to keep what I have.” On the other end, you have “very aggressive,” which means “I'm willing to make as much money as possible, even if that means taking a lot of risks along the way.”

If we go back to our roller coaster analogy, the three assets — cash, bonds and stocks — have different levels of ups and downs: Cash is fairly stable. Bonds are like a medium hill that just gets you warmed up, and stocks have a high climb and a sharp fall that, when combined, give the biggest thrill.

If an investor had a low risk tolerance, they might choose a conservative portfolio, which would usually contain a larger percentage of bonds and cash. On the other hand, if an investor had a high risk tolerance, they'd be more likely to have a more aggressive portfolio with a larger percentage of stocks.

The following chart from Schwab shows a generic example of asset allocations when it comes to risk tolerance. This is just one example and there are many variations of these models. That's why it's important for people to understand the terms and allocations before they invest.

Why risk tolerance matters

Let's say Rick, age 59, is nearing his retirement and feels worried that he hasn't saved enough to maintain his current lifestyle in retirement. To ramp up his savings, he fills his portfolio with a high percentage of stocks compared to bonds and cash.

Unfortunately, a market downturn comes along and Rick realizes he's losing money. He worries he's taken on too much risk and impulsively sells his stocks.

While Rick has alleviated his stress, he's also abandoned his long-term strategy and possibly locked in a loss. Since he hopped off the roller coaster at the bottom, he abandoned any opportunity he had to ride it back to the top.

Investors who take the time up front to understand their true risk tolerance can build a portfolio that reflects their true ability to withstand market volatility. With a calm and level head, they're able to stay the course through the turbulence and reevaluate with the help of their financial advisor when the market stabilizes.

A few words about volatility versus risk

Riding a roller coaster is not necessarily dangerous or risky, but the ride usually has ups and downs, or volatility. It's the same way with stocks or some other investments that we may call “riskier.” The meaning of risk in these cases isn't that they're bad investments, it's just that their prices can be subject to great fluctuations, or volatility. That's why the time-horizon for your investing goal is so important.

So why not just remain in cash and avoid all the ups and downs?

That's a great question. Over the long term, there tends to be a relationship between portfolio risk and reward. Generally, the greater the risk, the greater the expected return.

According to a study performed from 1926 to 2019, the average annual return increased from 5.33% to 10.29% when investors invested in 100% bonds compared to 100% stocks, respectively. In short, over time, stocks tend to outperform bonds or cash. I mean, if offered an option of choosing a 5.33% return or a 10.29% return, I think most investors would choose the latter.

But there's a catch: Typically, the greater the portfolio risk, the greater the volatility of those returns over time. That means there's a greater potential for loss. Let me explain further.

In that same study, the difference between the best year and the worst year of the 100% bonds portfolio was 40.75%. The same comparison for the 100% stocks portfolio was 97.33%. We also saw number of years with a loss increase from 14 for a 100% bond allocation to 26 for a 100% stock allocation. In short, while stocks experienced a greater return, it came with much more volatility and more years with negative returns. Thus, my roller coaster analogy.

How to pick your risk tolerance

Most financial advisors and investment tools use a risk tolerance questionnaire to help their clients select an appropriate risk tolerance. A series of questions helps determine appetite for risk and then gives a recommended portfolio based on those answers.

One good technique is to imagine a time when the market dropped significantly and for you to put yourself in that situation. Would you have been able to withstand a drop of that magnitude? It's much easier to do this if you actually lived through a market drop. What did you actually do? This can help you narrow down an appropriate risk tolerance.

A behavioral study by Tversky and Kahneman highlight the fact that most investors hate losses far more than they love gains — and that many investors overestimate the amount of risk they can emotionally handle. Having said that, there are also risks associated with being too conservative, such as failing to keep pace with inflation or running out of money in retirement.

But risk tolerance is only one consideration. You also need to determine whether your risk tolerance lines up with your risk capacity.

Risk tolerance versus risk capacity

Risk capacity measures a person's financial ability to take on risk. In general, investors with a longer investment time horizon have a higher risk capacity. They have a greater capacity for risk because they have time to recover if the markets fall. Someone who plans to retire in 30 years has much more time to wait for a market recovery than someone who plan to retire next year. But keep in mind that there's never a promise that the markets will recover. It's not a guarantee.

Here's another example where risk tolerance and risk capacity might not match. An investor may be very risk tolerant by nature. She seeks the thrill of starting her own business. She loves to go skydiving and rock climbing. If she invested according to her risk tolerance, she'd have lots of stocks and few bonds or cash in her portfolio.

Here's the kicker: This investor is in her 60s and plans to retire in a few years. Although by nature, she is willing to take on risk, she has a low risk capacity because she can't afford to take on risk like she could have in her 20s. If there were a market downturn, she'd stand to lose significantly, affecting her retirement lifestyle or even forcing her to work longer and delay retirement. She might not have enough time for the market to recover until she needs to begin accessing the funds.

On the flip side, if people invest too conservatively when they're young, they may not earn a return that outpaces inflation. This is another risk tolerance and risk capacity mismatch. They may be naturally risk adverse but have a huge capacity for risk as they don't need their funds for another 30 to 40 years.

What if I choose the wrong risk tolerance?

Investors typically discover they've chosen the wrong risk tolerance at one of two times: when the market drops, or when it rises quickly. Unfortunately, those are difficult times to make changes.

Here's why: If an investor sells some or all of their investments during a market low, they lock in a loss. It might be better to wait until the market recovers and then adjusting their risk tolerance at better prices.

On the other hand, if they see the market increasing and worry they're missing out because they invested conservatively, they might buy as the market is elevated.

It's important to remember throughout your investing journey that past performance is no guarantee of future results. Just because the market is decreasing doesn't mean it'll continue to decrease further. Also, just because the market is increasing doesn't mean it won't continue to go up.

How to right-size risk tolerance and risk capacity

Begin by answering the risk tolerance questions honestly. There's no reward for being super risk tolerant and there's no punishment for being super conservative. Also keep in mind the time horizon as that can help guide risk tolerance and risk capacity. If retirement funds aren't needed for another 30 years, this can help the investor be more comfortable assuming a level of risk that can help them achieve their goals.

Then, at least yearly, investors should reevaluate their risk tolerance and risk capacity. As we've shown, the passage of time and life circumstances likely affect both — and it's not advisable to make reactionary adjustments. If investors are unsure, it's a good idea to meet with a reputable financial advisor to determine the best time to make a change, if one is needed.