Risk tolerance is a commonly used term in the investment world, but its meaning and its implications, particularly for retirement, are often misunderstood. Essentially, risk tolerance refers to your comfort level with the prospect of losing money on an investment.^[1]

At one end of the spectrum, those who cannot stomach any potential loss from their investments are classified as having low risk tolerance and might employ a “conservative” investment strategy.^[1] Note that this has nothing to do with one’s political leanings. On the other hand, individuals who are okay with the prospect of some loss for the potential of higher gains fall under moderate risk tolerance. Lastly, those who are comfortable with substantial losses in the hope of even greater returns have a high risk tolerance and may employ an “aggressive” investment strategy.^[1] Note that all these terms are relative to one another.

The Purpose of Understanding Your Risk Tolerance

Understanding your own risk tolerance is crucial because it shapes the investment strategies you pursue and the financial goals you set.^[2] It helps strike a balance between the potential returns and the level of risk you’re comfortable taking before market conditions change. This understanding can affect how much you save, how you allocate your investments, and your overall financial planning.^[3] It is also informed by your financial situation and goals.

How Can You Understand Your Own Risk Tolerance?

There are a few steps involved in understanding your risk tolerance. First, you need to assess your financial goals and your timeline for achieving them. If you have long-term goals, you might be able to tolerate more risk. You also need to examine your emotional comfort with potential losses, as well as your financial capacity to absorb them.^[4]

However, it’s important to remember that self-assessment can sometimes be clouded by personal biases. That’s where an unbiased third party, like a financial professional, can be invaluable. They can use their expertise to assess your risk tolerance objectively and guide you in making sound investment decisions.^[3] A financial advisor can also serve as an unbiased sounding board, helping to keep your investments on track and your emotions from affecting your financial decisions.^[3] They can provide clarity and direction, helping you navigate the complexities of investing while aligning your financial plan with your risk tolerance and financial goals.^[2]

Really, the goal of understanding risk tolerance is to understand what kinds of financial decisions you should be making. If you’re not a professional investor, it’s understandable, yet costly, to get emotional with the swings of the market and change your investment approach based on how you feel about past results. A solid understanding of risk tolerance and the proper execution of incorporating your true risk tolerance is something a financial professional is well suited to help you achieve. If risk tolerance is something you struggle with, consider reaching out to one of our professionals for a complimentary review of your financial circumstances.