Plan for Tomorrow | Determining your personal risk tolerance level
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Determining your personal risk tolerance level

Mar 26, 2024, 6:33:14 PM | Reading Time: 7 minutes

When discussing investing, many of us may think of risk and picture the ups and downs of the market. The tradeoff between risk and return may cause anxiety in some people who prefer greater stability, while others are willing to take a more aggressive approach in hopes of higher returns. Since everyone’s comfort level is different, it’s important to better understand our personal risk tolerance and how to shape our financial strategy around these preferences to successfully achieve our goals for the future.

What is risk tolerance?

Risk tolerance is the willingness and comfort level of taking on risk, specifically when it comes to market volatility and how potential declines could affect your financial portfolio. Often measured on a spectrum, a person’s risk tolerance is how willing they are to take on risk or their openness to possible loss in exchange for a potentially higher return. For some people, the ups and downs of the market may be very stressful, and they do not want their financial portfolio affected by volatility. Others may be able to tolerate loss and prefer financial vehicles that have more exposure to market risk with a greater potential for growth.

How to measure risk tolerance

Part of understanding your financial mindset is identifying your risk tolerance and how you approach money management. Since the ultimate goal is to shape a financial strategy around short- and long-term objectives, knowing personal risk tolerance helps inform the steps for getting to the finish line. Along with using a risk calculator to help determine your current balance with risk and where you fall on the spectrum, you can also explore several key factors that can influence personal risk tolerance:

Speedometer 1. Comfort level

Identifying your risk tolerance takes exploring your willingness to take risks and your comfort level with loss and investing. Helpful questions to ask yourself include:

  • Do financial decisions make you anxious?
  • How comfortable are you with potential losses in your investments?
  • Are you willing to withstand some fluctuations in the market?
  • What would you expect from your investments if the market performs poorly over the next several years?

Checklist  2. Financial goals

Each person has a variety of financial goals, and those objectives can change throughout one’s lifetime. Whether the goal is to take care of loved ones and have a comfortable retirement, create enough savings for future medical care, or preserve a nest egg rather than grow it, understanding what you’re looking to accomplish can help inform the correct amount of risk.

Glasses 3. Age

Younger individuals can typically take on greater risk since they have more time for their financial portfolios to recover from market loss. Individuals who are nearing retirement may want to shift to lower-risk investments and financial vehicles to ensure their accumulated savings remain stable and available once they retire.

Calendar 4. Timeline

The time horizon is the amount of time you have until you want to reach a certain goal, like retirement. A longer time horizon usually allows for a higher risk tolerance, while a short timeline often leads a person to seek less exposure to risk. A portfolio can contain several savings goals and timelines and can evolve through different life stages.

Portfolio 5. Portfolio size

Oftentimes, the larger a portfolio, the more tolerant it is to risk, and vice versa. In general, individuals with more savings and greater financial security may have more freedom to take on risk, while those with less accumulated assets and perhaps higher debt may not have as much capacity to risk loss for a potentially larger gain.

The different levels of risk tolerance

Risk tolerance is typically influenced by one’s financial ability and their appetite toward risk, and once those factors are explored in more detail, it can be easier to determine where you fall on the risk spectrum. There are three risk tolerance profiles:

  • High risk tolerance

    Considered the most aggressive classification, being at the high end of the risk spectrum means the person is more comfortable with taking larger risks and seeks to grow their assets as much as possible. This high-risk, high-reward approach is often seen in larger portfolios with a longer timeline, where this person may feel that any loss now is exceeded by potential gain down the road.

  • Moderate risk tolerance

    Falling toward the middle of the risk spectrum, those who classify as having a moderate risk tolerance commonly want a more balanced approach between growth potential and long-term stability. This person may be more willing to take on some risk and can accept a moderate return potential in exchange for some fluctuations in their account value.

  • Low risk tolerance

    Also known as conservative risk tolerance, people who prefer low risk tend to choose investments and financial solutions that are considered safe and are minimally impacted by changes in the market. Most often, the priority is to avoid losses and protect assets over maximizing gains. While these individuals may want some growth potential, they are likely content with smaller gains and prefer more stability and predictability.

Building a financial portfolio around risk tolerance

Understanding your risk tolerance not only helps build a financial strategy that meets your goals and comfort level, but can help boost confidence and peace of mind around financial decision making. Partnering with a financial professional can help you identify your financial preferences and discuss the factors that influence risk tolerance. You can also explore possible solutions that can create a comprehensive portfolio and that make the most sense for your current goals and timeline. Most importantly, a financial professional can identify ways to revise a financial plan as retirement approaches and ensure it still aligns with your current risk tolerance and priorities.

The term financial professional is not intended to imply engagement in an advisory business in which compensation is not related to sales. Financial professionals that are insurance licensed will be paid a commission on the sale of an insurance product.