What is risk tolerance?

Your risk tolerance is simply the amount of financial risk you’re willing to take on when it comes to investing.

Risk tolerance is inherently tied to the risk versus reward of an asset. Generally, if a particular investment is high-risk, it has the potential to generate higher returns. But, it can also result in greater losses. If it’s lower risk, its returns might not be as lucrative, but it tends to be less volatile.

Risk tolerance is incredibly personal, which is why there’s no single approach to it. It depends on all kinds of factors, including your familiarity with investing, investing goals , investing horizon (i.e. the amount of time you plan to invest), current financial situation (including income stability), and how comfortable you are with uncertainty .

Is risk tolerance the same as risk appetite and risk capacity?

You might also see the terms ‘risk appetite’ and ‘risk capacity’ floating around. While they’re sometimes used interchangeably, and definitions can vary, there are differences between the three.

Risk appetite is a fairly broad concept that reflects your feelings towards risk and what you’re prepared to do to achieve your investing goals.

Risk capacity is a more objective measure. It’s about how financially able you are to take on risk. For example, if you suddenly lose your job and consequently have less money to play with, you might have less freedom in choosing high-risk investments.

Why it’s essential to know your risk tolerance

It’s crucial to understand your risk tolerance because it guides every single investing decision you make.

It can also contribute to your success as an investor. If you understand your risk tolerance really well and pick investments to suit it, you may find you’re in a better place to meet your financial goals (without losing sleep).

On the flip side, you could have a poor understanding of your risk tolerance, which means your investing strategy doesn't align with your actual ability to handle risk. In that case, you might make unwise investing decisions that could derail your goals.

Overall, you’ll find that once you know your risk tolerance, your investing journey becomes a much more enjoyable one. You’ll be able to work towards your wealth at a momentum that works for you, and you (hopefully) won’t stay up at night worrying about your money.

Remember as well that your risk tolerance can change over the course of your lifetime.

When you’re young and have a longer investing horizon, you might be more capable of handling high levels of risk. This is simply because you’ve got more time ahead of you (and possibly because young people tend to take more chances!).

On the other hand, as you approach retirement, you might prefer to protect your wealth – thus opting for a more conservative investing strategy that prioritises low-risk assets.

The three types of risk tolerance

While risk tolerance is pretty nuanced and depends on a huge number of (very personal) factors, it generally falls into three main categories.

Conservative risk tolerance

Any kind of investing comes with a certain amount of risk. However, investors who are more conservative are generally less comfortable with high-risk investments. Instead, they prefer stability and a lower chance of losing their money – even if that means missing out on higher returns.

They might invest in safer investments like blue-chip sh ares, cash, government bonds , and dividend-paying stocks (including dividend ETFs ).

Conservative investor case study – John, teacher, 50

John has been teaching for around 30 years and is looking to retire in the next five. Over his working life, he’s manage to build a fairly solid nest egg, mostly via his superannuation .

Because he’s hoping to retire fairly soon, John doesn’t have a huge amount of time to weather the volatility of high-risk investments. His priority now is to minimise financial losses and preserve the wealth he’s accumulated.

So, he logs into his superannuation account and switches to a more conservative investing strategy that prioritises low-risk investments, like fixed interest and cash.

Aggressive risk tolerance

On the other end of the spectrum are aggressive investors. They can handle the unpredictability of high-risk investments, as well as the possibility of sacrificing their money. But, it’s a sacrifice they’re willing to make, because their preferred investments also have the potential to deliver higher returns.

These investments typically include stocks in emerging markets or sectors, cryptocurrency , options, and futures.

Aggressive investor case study – Rita, marketing manager, 32

Rita has a very clear goal: she wants to buy a house in the next 5-10 years and needs to swiftly save enough for a deposit. She also has a fairly high income of about $120,000.

This is why she’s opting for a more aggressive approach to investing. She wants to save as quickly as possible, plus she has enough income to mitigate any losses.

So, she chooses investments that are known to be volatile but offer the potential for massive growth. These include stocks in sectors like tech and renewable energy, as well as foreign currency and emerging market ETFs .

Moderate risk tolerance

Somewhere in the middle is moderate risk tolerance. Investors who sit here look for a nice balance of risk and return – meaning they can handle some degree of risk for the chance to make decent gains.

For moderate investors, it’s all about diversification . A moderate investor’s portfolio might include a diverse mix of investments such as stocks, bonds, and ETFs.

They may also adopt an investing strategy like the core-satellite approach . This sees a small portion of their portfolio dedicated to riskier investments and a larger portion invested in stabler ones to offset any losses.

Moderate investor case study – Lee, electrician, 45

Lee has a couple of investing goals in mind. He wants to fund his children’s schooling and supplement his retirement savings by making extra contributions to his super .

He uses a core-satellite approach to choose a mix of investments that will help him achieve his objectives. Around 70% of his portfolio is dedicated to relatively stable assets like government and corporate bonds, while the remaining 30% is invested in growth stocks. This will help ensure that any losses incurred by his growth investments are balanced by more resilient assets.

Remember that these three categories are fairly broad. You could probably include multiple subcategories within each one, ranging from very conservative to mildly conservative or mildly aggressive to very aggressive.

Someone’s risk tolerance can also shift over time depending on changes to their investing goals, financial situation, and life stage.

How to figure out your risk tolerance

As we know, risk tolerance comes down to a series of (highly personal) factors. As such, there are several questions you can ask yourself to help determine yours.

• What are your investing goals? As the case studies above have demonstrated, your objectives will guide whether you go for high or low-risk investments, or a mix of the two
  
• What’s your investing horizon? If you plan to access your money in the immediate future, you may opt for a more conservative investing approach. Alternatively, if you’ve got more time to recover from market downturns, you could afford more risk
  
• What kinds of returns are you after? High returns may be super important, despite the high risk that tends to come with them. Alternatively, you may prefer safer investments with lower returns (Don’t forget, though, that returns are never guaranteed. Even if something has the potential for high growth, it could just as easily dip in value. And, nothing is ever 100% ‘safe’ when it comes to investing – it always comes with some degree of risk.)
  
• What’s your current financial situation? Think about how much you can afford to lose right now, as high-risk investments tend to come with a higher chance of losses. Also consider whether you’ve got enough stable income coming in, or a rainy day fund, to fall back on if things go belly up
  
• How experienced are you with investing? If you’re a first-time investor , you might prefer to dip your toe into investing by going for more conservative investments. After some time, though, you may be better able to handle risk
  
• How much do you know about investing? Different investments have their own level of risk, so you want to ensure you’re aware of the stakes before putting your money into them
  
• How important is investing to you? You might be willing to put more research into understanding the market and spend your spare time monitoring your portfolio. You may also be happy to reduce your expenses to allocate more money to investing
  
• How do you handle market downturns? An abrupt downturn could have you panicking and shedding your assets. Otherwise, if you find you typically buy up when the market’s low, you may have a higher tolerance for risk. If you haven’t experienced this kind of scenario before, think about how you’d react if all your investments suddenly dropped in value
  
• Can you maintain a long-term perspective? At Pearler, we subscribe to the idea that investing should be a long-term game . Think about your own ability to keep a long-term perspective in spite of short-term fluctuations
  
• Does risk make you nervous? Your personality is a major factor in your risk tolerance. If uncertainty makes you stressed, you may be more comfortable with a lower-risk investing strategy

These questions are merely designed to be a helpful starting point. A licensed financial adviser can give you further support on figuring out your risk tolerance and choosing the right investments to match.