Imagine that you are just starting your career and decide to invest your extra income. But when you begin your research, you come across terms you have never heard before. Risk tolerance is one of the biggest topics you must understand before jumping into the investment world.

In fancy terms, it is termed risk tolerance. But, it is just how comfortable you are with the market's movement. When you try to understand what is risk tolerance, you need to know that multiple factors can influence it. So, wherever you fall on the risk tolerance scale, it helps you to see where you stand. 

Let's go over what is risk tolerance and how it can help you put your portfolio together.

What is Risk Tolerance - Table of Contents

What Is Risk Tolerance?

Risk tolerance is the degree of risk investors are willing to endure when a volatile market. Considered to be one of the most important aspects of investment, risk tolerance determines the type and amount of investment that individuals can choose. 

Greater tolerance is synonymous with investments in Exchange-Traded Funds (ETFs), stocks, and equity funds, but lower risk tolerances are often associated with purchasing bonds and income funds.

Understanding Risk Tolerance

Any investment you make in the market has some degree of risk involved, and knowing your level of risk tolerance helps you plan your portfolio. Based on how much risk you can take will determine how much you can invest. 

Risk tolerance assessment forms are easily available online that include questionnaires and surveys. As an investor, you may also want to review historical returns for different stocks and assets to determine their volatility. 

One major factor that affects risk tolerance includes the timeline. When you have a goal with a long timeline, you may invest in high-risk assets like stocks. Conversely, if you have short-term goals with a short timeline, you may invest in low-risk cash investments. 

As an investor, your future earning capacity and other assets like pension, home, or inheritance can affect your risk tolerance. Investors can take bigger risks with investable assets when they have more reliable and stable funds. Also, investors with larger portfolios are more tolerant of risks as their loss percentage is smaller. 

Types of Risk Tolerance

1. Aggressive Risk Tolerance

Investors with a high-risk tolerance are willing to lose money to gain better results. So, aggressive investors are quite market savvy and understand the volatility of securities. They follow strategies to achieve higher-than-average returns. Their investments emphasize capital appreciation rather than preserving principal investments or income. Investors' asset allocation includes stocks and little to negligible allocation to cash or bonds. 

2. Moderate Risk Tolerance

Moderate investors are those who want to grow their money without losing much. Their main goal is to maintain a balance between opportunities and risks. This type of risk tolerance is known as a 'balancing' strategy. In most situations, moderate investors start by developing a portfolio that includes a mix of bonds and stocks in the 60/40 or 50/50 structure. 

3. Conservative Risk Tolerance

Conservative investors accept little to no volatility in their portfolios. These are often people in the retirement age group and are unwilling to incur any losses in their principal investment. They also have short-term investment strategies. These types of investors target those stocks that are guaranteed and highly liquid. Conservative risk tolerance investors generally opt for Certificates of Deposit (CDs) or money markets.

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Factors That Influence Risk Tolerance

Now that we understand what is risk tolerance and the different types let's take a look at some factors that can influence your risk tolerance: 

Factor #1. Timeline

Your timeline will go hand-in-hand with your goals. A long timeline means you can take more risks, whereas a short timeline means you want to invest more safely. With a long-term timeline, you can take more risks as you have time to recover any lost income. But with short timelines, you can only invest in stable assets.

Factor #2. Goals

The goals you choose for your investment portfolio can impact the risk you take and the timeline you choose. If you have money goals, you want to achieve in the next 3-5 years; then you might want to moderate your investment strategy. On the other hand, if your goal is to plan for retirement, and you have just entered the workforce, then you need to invest more aggressively as you have more time. 

Factor #3. Portfolio Size

This will affect you less than your timeline or goals, but it is worth mentioning for some investors who prefer having larger portfolios. This means that they are more willing to take more risks. Having a large portfolio with millions of dollars differs from having a small percentage.  

Factor #4. Age

Your age is also highly connected with the timeline and goals regarding risk tolerance. When deciding on your goals, your age is also factored in. So, you could be in your 20s, but depending on your goal - buying a house or planning your retirement - your age is also a factor. 

Factor #5. Investor Comfort Level

Your personal comfort zone plays a huge part in your risk tolerance planning. In the end, you can have a large portfolio with plans to invest millions and retirement goals with a more than 30-year timeline. But, if you are someone who cringes with every drop in the market, you will not want to invest in high-risk-tolerant stocks. So, your comfort levels affect your risk tolerance in the market.

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How Does Risk Tolerance Impact My Returns?

This is a question that all investors have in their minds every day.

Generally, higher risk equals higher returns. So, it is a fair trade-off if you are willing to take on more risks in the hopes of better returns. But, the reality is quite different.

Stocks provide higher returns when compared to bongs. But we also know that there is a level of volatility involved in the stock market. Just because the market has behaved a specific way in the past does not mean it will not happen again.

Your risk tolerance is what keeps you realistic about your returns. It will give you a deeper understanding of the variability in the market. If you are an aggressive investor with a higher risk tolerance, you will expect a larger variability in investment returns.

On the other hand, if you are a moderate or conservative investor, your returns will be more predictable. But your returns will also be smaller than those of an aggressive investor.

In the end, if you know your risk tolerance, you can make the best investment strategy for yourself.

Risk Tolerance vs Risk Capacity Differences

Your risk tolerance is the measure of how much risk you are willing to take in the market, whereas, on the other hand, risk capacity is your total financial picture. Some differences between the two are: 

Conclusion

When you are at the start of your career and are wondering what is Risk Tolerance, it is important to have a long-term vision. Watching your investments fall from one day to the next is hard. But, if you do not invest that money for tomorrow, you have to realize that the end game is what matters. 

The stock market averages a 10% annual return but does not deliver that same year after year. Some years it can be higher than 30%, and some days less. So, measure your growth over time. Make sure that you reevaluate your risk tolerance and make adjustments accordingly.