Risk tolerance definition investing

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Here is a simple risk tolerance definition: Risk tolerance is the level of risk and uncertainty that you can afford to take and are willing to take. Your risk tolerance will determine the makeup of your portfolio, or the collection of investments that you choose to make and manage. This is not a matter that is set in stone. Investment risk tolerance is determined by a few different factors like these that we will discuss in the next section. Any source that offers you investment tips without knowing anything about you is likely giving you poor advice.

Diversification One strategy that many investors use to minimize the total risk that they are exposed to is diversification. The principle behind diversifying your portfolio is basically that you want to avoid having all your eggs in one basket. A large, diverse investment portfolio might contain a mix of: Stocks, bonds Real estate Other investments ETFs and index funds are often a great way to get started investing in a diverse portfolio.

Some holdings might be riskier to help grow the portfolio, while others might be steadier to help keep the portfolio from suffering serious losses. By adding more stocks to a portfolio, for instance, money managers can make the portfolio more aggressive. Alternatively, they might scale back risk as an investor by putting more of your funds into bonds. Risk tolerance factors Your personal risk tolerance is determined by a few factors.

Goals What are your investing goals? If you want to make money quickly—or make a lot of money—you may need to become more comfortable with making higher-risk investments. On the other hand, options like individual company stocks might present the possibility of faster growth; imagine if you had invested in Facebook or Apple during their early days! However, for every Facebook, there are hundreds of apps that never find success. Investing in individual companies that promise short-term growth is almost always riskier, but if your goals are to make it big, you may be pushed more in that direction.

Age and time horizon Your age is also a relevant factor when determining your investment risk tolerance. Younger investors have plenty of time to ride out the bumps in the stock market, so financial advisors and robo-advisors may often suggest that they choose a more aggressive, risky portfolio allocation.

It may be risky in the short term, but because the stock market has historically trended upward in the long term, it is likely to turn out well. Older investors, on the other hand, may be more comfortable with a lower-risk portfolio that consistently grows in a dependable way. The amount of market risk you can stand is your risk tolerance. In simple terms, it is how much you are willing to be unsure about and how much money you're willing to lose , in the face of possible gains.

For example, if you're unwilling to lose much, or any, of your capital , you'd have a very low tolerance for risk. If you don't mind risking some of your money for the chance to make big gains, your risk tolerance would be higher. Your risk tolerance depends on many factors, both personal and financial.

Once you know how much risk you can tolerate, you can invest in line with your values and comfort level, and build a portfolio that matches your risk profile. How Risk Tolerance Works You can gauge your own level of risk with an online calculator or by talking to a financial planner. Financial planners use a person's risk tolerance to tailor the financial advice they give. They can also use risk tolerance to identify their clients' investing styles as aggressive, moderate, or conservative.

Firms use these three categories as a shorthand way to describe asset options, suggest asset allocations , or offer strategies to their clients. Risk tolerance also involves a feature known as "risk capacity," which identifies the amount of risk you can afford to take. It differs from the risk you are willing to take.

Suppose you have just started a new career and are planning to retire in 40 years. Your income is on the low side, and you have nothing in savings, but your cost of living is low, and you're young, so those things will come in time. Suppose also that it's in your nature to play big, roll the dice, and take leaps when given the chance. In other words, you are risky by nature. Your risk tolerance is high. Given all of these details, it makes sense that you'd go for a more aggressive approach, but your income and savings are low, so you might not be able to weather a severe price drop in your stocks.

Note Even if you have decades before you retire, it is still wise to have a diverse portfolio , with a variety of asset classes, including stock and bonds. While you may have a high tolerance for risk, your capacity for risk is lower. In that case, you might be better served with a more conservative portfolio than you desire, to preserve the assets you'll need to retire.

Assessing Risk Tolerance If you have a financial planner , they might have tools such as risk tolerance tests, which come in a wide range of styles. They may also ask how you approach risk in other parts of your life. You may be asked to rate your reaction to a given scenario on a sliding scale. You'll also answer complex questions that make you think about the way you handle money and risk in all parts of your life. What would you do?

Do nothing Wait a few months to decide Sell your stocks promptly An aggressive investor would most likely do nothing. A moderate investor might wait a few months to decide. A conservative investor might sell their stocks right away to stop future losses.

Note Financial planners use questions like this to build a portfolio of assets that will match your comfort level and needs over a long span of time. The idea is to keep your investing progress on track, in spite of how you react to single upsets. Types of Risk Tolerance On a scale from least to most risky , the three levels of risk tolerance are: Conservative: If you have a conservative risk tolerance, you would prefer to feel safe in how you choose to invest.

You would rather avoid the risk of loss than take a chance on major gains. People with this risk profile tend to be older and less wealthy than others.