Risk tolerance: What it is, why it’s important & what influences it

Whether you’re saving for retirement, a home down payment, your child’s college education or another goal, investing can help you get there. Investing can be intimidating but understanding your risk tolerance is key to making smarter choices that align with your financial goals and comfort level. Risk tolerance can help you find the right balance between potential gains and potential losses, setting up the potential for long-term success.

Read on to learn what risk tolerance is, what influences it and which risk tolerance category you fall into.

Risk tolerance is the level of risk you’re most comfortable with when it comes to financial gains and losses. But it isn't just about how much risk you can afford to take; it's also about how much risk you're comfortable taking. It's a complex interplay of your financial situation, your investment goals, and your emotional response to market fluctuations.

Risk tolerance varies from person to person and often changes throughout your life. It’s important to understand your risk tolerance so you can select investments that are most right for you.

There are five factors that can affect your personal risk tolerance: time horizon, financial goals, age, overall portfolio and diversification, and comfort level.

Time horizon refers to an estimated amount of time you plan to hold an investment until you need the money. It can significantly impact your risk tolerance. If you're investing for a long-term goal, like retirement, you can typically afford to take on more risk because you have time to recover from potential market downturns. However, if you're investing for a short-term goal like a down payment on a house, you'll likely want to opt for a more conservative approach. So those who don’t need the money for decades generally have a higher risk tolerance than those who need the money in the next couple of years.

Financial goals go hand in hand with time horizon. Long-term goals can withstand a higher risk tolerance than short-term goals. Referring again to retirement, if it’s 35+ years away, you can afford to take on more risk because you have time to ride out market fluctuations. However, if retirement is five years away, you may want to start shifting to more conservative investments to protect against potential market downturns.

In most cases the younger you are, the higher the risk tolerance you typically have. This is mostly due to the fact you have more time for your investments to grow and recover from market volatility. If you’re starting your first job, with decades to retirement, you likely will have a greater risk tolerance, and your investments can be more aggressive. But if you’re retired, you’ll most likely want to generate a steadier income and reduce your exposure to market volatility.

Being diversified in your investments means your portfolio is made up of many different types of assets, each with varying risk levels. Your risk tolerance likely will be higher if you have a diversified portfolio versus having all your money in one type of investment. “Diversification is a pretty big factor in absorbing some risk versus having all your eggs in one basket,” says Brent Robinson, Advice Services consultant at Thrivent. If one type of investment tanks, your other investments can help balance out the downturn.

Your personal comfort level also comes into play. Even if you’re young and have an extended time horizon to meet your financial goals, you may not be comfortable with riskier investments. If you panic during market downturns, your investment strategy will differ from the person who is comfortable with market fluctuations.

When do you typically have the lowest investment risk tolerance? And when do you typically have the highest investment risk tolerance?

While your risk tolerance can fluctuate throughout your life, your risk tolerance is generally highest when you’re young and starting to save for financial goals that are years or decades away. It’s lowest when you’re saving for short-term goals or if you’re already in retirement.

“If you’re in your 20s and starting to invest for retirement 40 years away, you have a relatively high risk tolerance. But if you’re in your late 50s and looking at retiring soon or paying for your kid’s college, your risk tolerance is lower,” explains Mike Kremenak, president of Thrivent Funds.

Consider these risk tolerance examples to help you identify where you might fall on the spectrum:

• A 22-year-old woman just graduated from college and started her first job with an employer that offers a retirement plan. She chooses riskier investments for her 401(k) because she knows she won’t need to access the money for 40 years. That means her portfolio can handle the ups and downs of the stock market. She has a high risk tolerance.     
• A 60-year-old man has been saving and investing for 40 years. He hopes to retire in the next five years and wants to help his child buy a house in a couple years. Since his financial goals have a shorter time horizon, he has a low risk tolerance.   
  

There are three main levels of risk tolerance in investing: aggressive, moderate and conservative. Let’s explore these.

“Aggressive would be the people willing to take the most risk,” explains Kremenak. These people’s sole goal is to maximize returns, and they aren’t concerned about underperforming investments because they’re optimistic about long-term rewards. They are comfortable taking bigger risks because they don’t expect to withdraw their investments for a long time. An aggressive investor’s portfolio would be heavy on stocks and equity exchange-traded funds. These investments have the potential for higher returns but also come with greater volatility and risk.

People who fall into the moderate category are investing for the medium to long term. They can withstand the usual fluctuations of the market if it nets a higher return. But if the volatility lasts too long, a moderate investor may consider withdrawing a portion or all of their investments. Aiming to strike a balance of riskier and lower-risk investments, their portfolio may lean toward mutual funds, exchange-traded funds and bonds.

Those with a conservative risk tolerance want to take on the least amount of risk possible. They are willing to trade lower returns and slower growth for more stability, especially if they need their money in the near term. Bonds and money market funds are good matches for conservative investors.

When evaluating your risk tolerance, you should also think about your risk capacity. The concepts sound similar, but there’s a clear distinction. Risk tolerance is the level of risk you’re comfortable with on an emotional level. Risk capacity refers to your financial ability to withstand losses and considers factors including your income, expenses, assets and liabilities.

It’s important to consider both when you’re choosing your investments, because they don’t always align. For example, a young person may have a high risk tolerance, but if they have an unstable income, high-interest debt or short-term goals, their risk capacity is low. Conversely, someone who is uncomfortable with investing may have a low risk tolerance even if their financial ability to withstand more volatility indicates a high risk capacity.

There are several ways to figure this out. Start by doing a step-by-step walk through the factors that affect it, and identify where you are on the spectrum, including your time horizon, financial goals and age.

You’ll also want to evaluate your risk capacity (how financially able you are to handle losses) and understand your emotional risk tolerance (how you react to market drops).

Consider taking a risk tolerance quiz, a questionnaire that asks about your investment experience, your reaction to losses and what your market expectations.

Risk tolerance can shift throughout your different life stages as your financial goals, obligations and timelines change.

At this stage, you have many years until your retirement and likely have fewer financial responsibilities, such as family and debt. You also have more flexibility to recover from market downturns. You may start out investing more aggressively in stocks, knowing you can weather market volatility. However, as you begin to grow your family, take on a mortgage or other debt, you may adjust your risk tolerance.

Higher salaries enabling you to accumulate more assets, along with the increasing financial obligations of family and your own retirement planning, are consistent with this stage. You may adjust your portfolio to a mix of stocks and bonds, still seeking growth but reducing your exposure to risk.

At this stage, it’s likely you have a goal now of preserving wealth and minimizing exposure to market downturns. You need to manage your withdrawals and perhaps still generate a little income. You may shift your portfolio to investments that will help you maintain a steady cash flow and minimize against inflation. A little growth is good to hedge against inflation.

There are common pitfalls you want to avoid when evaluating risk tolerance.

• Allowing emotions to drive your financial decisions 
• Neglecting to re-evaluate your risk tolerance over time 
• Failing to diversify your assets 
• Not paying attention to time horizon, or when you’ll need the money 
• Using someone else’s portfolio as a guideline for your own 
• Avoiding the reality of inflation 
  

Investing is key to building wealth, but you must understand your risk tolerance so you can choose the investments that are best for you.

By considering your time horizon, financial goals, age, overall diversification and comfort level, you can determine whether you’re an aggressive, moderate or conservative investor and build your portfolio accordingly.

Connect with a Thrivent financial advisor who can help ensure your investment strategy is aligned with your financial goals. They can also help you review and rebalance your portfolio regularly.