What Is Risk Tolerance?

Risk tolerance is your ability and willingness to see potential losses in your investments in exchange for the promise of greater returns.

Everywhere you put your money has a level of risk. Savings accounts, certificates of deposit, and bonds are typically considered low risk. Investments like stocks and mutual funds are higher risk.

Generally, low-risk investments will earn you less than high-risk investments. But with high risk, your earnings aren't guaranteed.

How Your Risk Tolerance Affects Your Investments

None of us wants to lose money. But some of us are more willing to risk losing money in the short term if it means we could end up with more money in the long term.

The level to which you're willing to take that risk (in the hopes of big gains) is your risk tolerance.

As a general rule of thumb, the younger you are, the riskier you can be with your investments. Since you have a long time until retirement, you have a long window to recover from any losses.

But if you're nearing retirement and want to maintain a steady income, then you'll likely want low-risk assets.

These two options refer to your “time horizon” — how long you have until you'll need the money that you've invested.

READ MORE:

• How To Invest In Your 20s
• How To Invest in Your 30s
• How To Invest in Your 40s
• How To Invest in Your 50s
• How To Invest in Your 60s

Risk and your investment time horizon

Risky investments are volatile in the short term. 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 many years, that 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 impossible to know whether the next 20 years will be a period of 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: Aggressive, Moderate, and Conservative. 

Aggressive risk tolerance

If you're willing to endure large short-term fluctuations in exchange for the promise of higher returns over a longer period, then you want an aggressive portfolio.

This typically means the majority of your portfolio is in stocks, with a smaller portion in bonds and cash. For example, you might have:

• 80% in stocks
• 10% in bonds
• 10% in cash (e.g., high-yield savings accounts, certificates of deposit, money market funds) 

Generally, aggressive investors have long investment time horizons, often 20+ years. 

Moderate risk tolerance

Moderate investors have some risk tolerance, but less than aggressive investors.

If you're comfortable with some year-to-year volatility but are approaching retirement or significant life changes, you may not want to risk big losses.

Your portfolio might look like:

• 60% stocks
• 30% bonds
• 20% cash equivalents

Conservative risk tolerance

If your priority is to protect your principal and you're willing to forego the potential of higher returns, then your portfolio should be conservative.

This is often suitable for retirees relying on income-producing assets — for example, a retiree covering their annual expenses with Social Security payments, combined with interest from bonds and CDs, or dividends from their stock investments.

How To Determine Your Risk Tolerance

First, consider your investment time horizon:

• Are you planning to hold your investment for decades, a few years, or less? 
• Are you comfortable with losing a portion 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.

But if you have shorter investment horizons and are averse to the prospect of losses, your risk tolerance may be lower. 

There are also online surveys you can take, like this one by Vanguard.

Remember that all levels of risk tolerance are acceptable and that they can vary widely depending on your financial goals and life stage.

READ MORE: Short-Term vs. Long-Term Financial Goals

How To Diversify Your Portfolio To Reduce Risk

You can fine-tune the overall risk of your investments by having a diversified portfolio that includes different asset types.

For example, 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, you can reduce risk by investing in a wide array of stocks that cover different businesses and industries. An index fund that tracks the S&P 500 is a great way to do this.

With index funds, you acquire fractional shares in hundreds or thousands of different companies, thereby reducing your dependence on any single company. 

If you're not sure where to start, Erika recommends Webull as a beginner-friendly investing app. You can buy stocks, index funds, and more, with just a few dollars.

FAQs

TL;DR: Know Your Investing Risk Tolerance

Risk tolerance is your willingness to accept potential investment losses in exchange for higher returns.

Younger investors can typically handle more risk since they have decades to recover from losses, while those approaching retirement should focus on safer investments.

Either way, diversify with different asset classes — this will reduce your overall portfolio risk regardless of your tolerance level.