What Is Risk Tolerance?

Risk tolerance is defined by your ability and willingness to endure potential losses of some or all of your original investment in exchange for the promise of greater returns.

Among financial investments, which include cash in your bank account, each option carries both an expected long-run return and an associated risk of loss. The extent of these risks and expected returns can vary substantially across investment types such as cash, bonds, stocks, real estate, and more complex assets such as cryptocurrencies. 

How risk tolerance affects your investment choices

The choices you make on how, or whether, to invest your money play a pivotal role in determining the overall risk level of your finances. While we all harbor personal motivations for opting for more or less risky investments, it is crucial that these investments align with your true risk tolerance. 

For instance, if you are nearing retirement and your primary objective is to maintain a steady level of assets, then your investment choices and risk tolerance may not be aligned if you are heavily invested in high-risk assets.  

Let’s discuss the relationship between risk and expected returns as it relates to common investments.

Savings and checking accounts

Holding U.S. dollars carries minimal risk of diminishing your balance, although the value of your cash can erode over time due to inflation. In fact, the “real” return of holding cash is often negative when accounting for inflation.

High-yield savings accounts offer the option to hold cash with higher returns than checking accounts while maintaining low risk. Generally speaking, lower-risk cash investments will, in exchange, have lower returns.

Certificates of Deposit (CDs)

Certificates of Deposit (CDs) may offer returns that are higher than savings accounts, but with the requirement that you cannot withdraw your funds for a period of time or face a penalty. The primary “risks” with CDs are the possibility of needing the funds early and having to incur a penalty or rates increasing during the investment term, leaving you locked into a rate that might be lower than the prevailing savings rate. 

Bonds

Bonds share similarities with CDs — you effectively lend money to an institution, which repays you at the end of the term, often with periodic interest payments. Some bonds are issued by the federal government, offering risk and returns similar to CDs. Bonds can also be issued by local governments and businesses, where the risk of non-repayment or default is higher, leading to corresponding variations in price.  

A lower bond price corresponds to a higher yield or expected return. Bonds are tradable, and if you purchase a bond with a 4% interest rate and market interest rates rise, the bond’s value decreases. Conversely, if interest rates decline, the bond’s value increases. So you will have interest rate risk if you don't plan to hold the bond to maturity.

Stocks

Stocks are generally considered riskier holdings than bonds but offer the potential for higher returns. For example, many bonds currently yield around 5% (without reselling), which is relatively high over the past two decades. 

Meanwhile, investing in an S&P 500 index fund, which represents approximately 500 highly valued companies trading on American stock market exchanges, has historically returned about 10% annually.

However, these annual returns have fluctuated between 30% gains and nearly 40% losses within the past 20 years. Of course, years with annual gains have far outnumbered annual losses, but how much risk you're willing to accept, or what your risk tolerance level is, is ultimately a personal decision.

For anyone who wants to try investing in the stock market, we recommend starting with Webull, which is a user-friendly discount brokerage that has been around for years.

Diversifying your portfolio to reduce risk

Individuals can fine-tune the overall risk of their investment strategy by having a diversified portfolio that includes different asset types. For example, if you hold a significant amount of cash, you can increase the risk and expected returns of your total portfolio by adding stocks and bonds. Conversely, if you are holding many individual stocks, you might lower your overall risk by adding bonds and index funds. 

Diversification can also reduce risk within asset classes. For example, bonds’ rates may fall or rise over time. You can hedge against uncertainty by investing in both short-term and long-term bonds. Short-term bonds lock in your rate for months and provide liquidity upon maturity, while long-term bonds offer rate stability for years. 

Within the realm of stocks, you can reduce risk by investing in a wide array of stocks, such as by purchasing index funds that track the S&P 500 or the “total market.” For a small management fee, these funds allow you to acquire fractional shares in hundreds or thousands of different companies, thereby reducing your portfolio’s dependence on any single company. 

Risk and investment time horizon

Risky investments are inherently volatile in the short term, with the potential for substantial losses. As previously noted, the S&P 500 has witnessed a wide range of annual returns, ranging from nearly 40% losses to nearly 30% gains over the past two decades.  

However, over extended periods of many years, that annual market volatility smooths out, dramatically reducing the likelihood of losses.

For instance, in the last century, there has never been a 20-year period where the S&P 500 index had an overall negative return — even during the period that included the Great Depression and the start of World War II.

Even 20-year periods can experience volatility. Over the past century, there have been multiple 20-year periods with average returns of about 6% to 8% (excluding inflation), and other 20-year periods with average annual returns greater than 15%. It’s effectively impossible to know whether the next 20 years will be a period of relatively low or high returns, but longer investment horizons dramatically reduce portfolio risk.  

In general, the shorter your time frame the less risk you should assume.

Types of risk tolerance

There’s a spectrum of risk tolerance, but it’s helpful to categorize them based on portfolio choices, including Aggressive, Moderate, and Conservative. 

Aggressive risk tolerance

Investors with high-risk tolerance are willing to endure large short-term fluctuations in exchange for the promise of higher returns over a longer investment horizon. These investors typically allocate the majority of their portfolio to stocks, with a smaller portion in bonds and cash. 

An aggressive portfolio might consist of 80% in stocks, 10% in bonds, and 10% in cash (e.g. cash, CDs, and money market funds).  Generally, aggressive investors have long investment time horizons, often exceeding 20 years. 

Moderate risk tolerance

Moderate investors have some risk tolerance, albeit less than aggressive investors. They are comfortable with some year-to-year volatility but may be approaching retirement or significant life changes, and may not want to risk meaningful portfolio losses in case they need to utilize their savings (e.g. to buy a house or pay for children’s college expenses). 

Investors with moderate risk tolerance may have a portfolio with roughly 60% stocks, 30% bonds, and 10% cash equivalents. 

Conservative risk tolerance

Conservative investors prioritize principal preservation and are willing to forego the potential of higher returns to safeguard their current assets. This approach is often suitable for retirees relying on income-producing assets. 

For instance, a retiree that is covering their annual expenses with Social Security payments combined with interest from bonds and CDs, or dividends from their stock investments. Conservative portfolios predominantly consist of bonds and CDs, possibly dividend-paying stocks.

Related: What is asset allocation and why is it essential to investing?

How to determine your risk tolerance

There are multiple ways to help ascertain your personal risk tolerance. 

First, consider your investment time horizon: are you planning to hold your investment for decades, a small number of years, or less?  Reflect on whether you’re comfortable with losing a portion or most of your investment over a brief period. 

If you’re focused on longer investment horizons and can tolerate short-term declines, you may have a high-risk tolerance. Conversely, if you have shorter investment horizons and are averse to the prospect of losses, your risk tolerance may be lower. 

One formal approach involves taking online surveys such as one provided by Vanguard. These surveys include questions on topics discussed in this article and provide deeper insights into your risk tolerance. 

Remember that all levels of risk tolerance are acceptable and that they can vary widely among individuals and across different life stages. However, it is critical to ensure your financial investments are aligned with your risk tolerance. 

FAQs

What are the factors of risk tolerance? 

Risk tolerance may be affected by your age and investment time horizon, your experience investing, your personal comfort with short-term losses, and your current financial capacity. 

Who should have a high-risk tolerance?

Risk tolerance is a personal choice, and not everyone needs to take risks. However, if you’re relatively young and have the financial capacity to hold investments over decades, you may experience greater returns by taking on higher levels of risk. Note that diversification may allow you to significantly reduce risk without meaningfully reducing expected returns. 

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