Saying that you would “bet the farm” is an expression of confidence in a particular outcome. Of course, many people who have uttered that phrase are fortunate that they didn't, in fact, gambling away their house or something else of meaningful value to them, like their retirement savings, their child's college fund, or the cash they've been saving for a new house.
In the world of investing, there is no such thing as a certain outcome. There is, however, predictable risk. And that’s the topic of this article: risk tolerance. In this article, we’ll define what risk tolerance is, the different kinds of risk tolerance, the difference between risk tolerance and risk appetite, how time factors into an investor's risk tolerance, how an investor determines their level of risk tolerance, and strategies for managing risk.
What is risk tolerance?
Risk tolerance is a measurement of an investor’s willingness to accept a degree of variability in their investment returns. It’s a way of asking an investor, “What’s the absolute worst thing that could happen to your portfolio that still wouldn’t cause you to panic and sell?”
For example, it’s one thing for an investor to say they can tolerate a 10 percent drop in their portfolio during a multi-year bear market. If they have time on their side, they may have confidence that they will recoup their money over time. But markets don’t always behave in an orderly fashion. How would that investor feel if their portfolio lost 10 percent of its value in a week, or in a month, or in the year leading up to their retirement? Would they have the same level of confidence? Every investor should understand how much capacity they have, psychologically, to handle large swings in the value of their investments.
For that reason, risk tolerance is a qualitative measurement. Understanding an investor’s level of risk tolerance is not about assigning a specific dollar loss or percentage loss to an investor’s decision making. It’s a way of assessing how an investor would feel if their portfolio lost a significant amount of value and their degree of confidence to stay with their plan.
It’s important to note that risk tolerance only comes into play for the money that an investor is willing to put into the stock market and other securities. This does not include the liquid funds (i.e. cash) that they are setting aside for a down payment on a house, or the vacation fund. The money they are subjecting to risk is money that is being set aside for intermediate and long-term goals and money that they would not need to have available to them should they suffer a life-altering event like a job loss or medical emergency. Even the most risk-tolerant investors would not want to add an element of risk to their own emergency fund. Risk tolerance is assigned to the money that is being invested above and beyond that base.
Understanding the different kinds of risk tolerance
There are three basic levels of risk tolerance: aggressive, moderate and conservative.
Aggressive Risk Tolerance – Investors with an aggressive risk tolerance tend to be very knowledgeable about the factors that influence market movement move and how that movement will affect different asset classes (i.e. stocks, bonds, real estate, currencies, etc.). Their goal in investing is to achieve maximum returns, and they are willing to accept maximum risk in order to achieve that goal. To that end, they are comfortable having a portion of their portfolio invested in volatile securities such as small company stocks (even penny stocks) that may drop to zero.
Moderate Risk Tolerance – Investors with a moderate risk tolerance will accept some risk to their portfolio’s value but seek to find a balance. Unlike someone with an aggressive risk tolerance, they typically have goals with time horizons of five to 10 years and are therefore more concerned about sheltering some of their profits as their time horizon becomes shorter.
Conservative Risk Tolerance – Investors with a conservative risk tolerance are usually novice investors who do not have a great deal of investment knowledge. Their primary goal is to preserve their capital even if it means missing out on potential returns. “A bird in hand” is probably their life mantra.
The purpose of these classifications is not to suggest that an investor with an aggressive risk tolerance shouldn't have some conservative investments or vice-versa. It's simply to understand how you may be wired. If you have more of a conservative risk tolerance, you may find it comforting to work with an advisor who can hold your hand through the process. If your risk tolerance is more aggressive, you may need to have mechanisms in place that will automatically keep your portfolio in balance.
How time factors into risk tolerance
Although assessing an individual’s level of risk tolerance is often framed in the context of how much money an investor is willing to lose, a better variable to consider is the timeframe in which the investor will need the money.
Before we look at how time factors into risk tolerance, it’s important to understand the difference between risk tolerance and risk appetite. Imagine a woman who has always loved skiing, especially on the double black diamond slopes. She has a high-risk appetite. Throughout her life, she takes some hard falls, but she always recovers. However, as she reaches her seventies she wisely decides to tone it down a bit. She gets a bone density scan that confirms that, at this point in her life, a wreck on the ski hill would put her in bed for months, and she certainly doesn’t want that. Her risk appetite is just as high as ever, but her risk tolerance has decreased. Many retired athletes maintain a strong desire for playing their sports. However, they arrive at a point where their tolerance for training and preparing their bodies to compete at the level they need to is no longer worth the financial reward. On the other hand, many books have been written encouraging people who are intolerant of change to get out of their comfort zone (i.e. to increase their risk appetite) so they don’t miss out on potential rewards.
So how does this fit in with investing?
Younger adults who are single or are married with no children have time on their side. They are 40 years away from retirement, and probably at least 20 years away from having to think about a child going to college. After setting aside some savings for their emergency fund and maybe a down payment for a house, they should be encouraged to invest a substantial amount into more volatile securities such as growth stocks because that’s where they are going to get the best return, albeit with more risk. In many cases, young investors may have both a high-risk tolerance and a high-risk appetite. These investors will be willing to take a great deal of risk to maximize their reward. They may truly be willing to "bet the farm" in order to achieve their goals. In both cases, the challenge is to ensure that their goals are aligned with their risk tolerance. If they are too conservative, they may wind up with a portfolio that is not growing at an adequate pace. If they are too aggressive, they may wind up in a situation where their portfolio suffers losses that they will not be able to recover from when their goals and risk tolerance changes.
For middle-aged adults who are married and/or have children time is still favorable, but the clock is ticking. And because there are more dependents, the amount of income available to invest is at a premium. In this case, balance and trust are the key words. The money that’s needed for college, educations, weddings, etc. needs to be sheltered more and more as those dates come closer. On the other hand, there can still be a higher tolerance for risk in funding their retirement, which may still be some time away. In both cases, it’s important to trust your plan. However, this is also a time when many investors start to re-evaluate their goals and, in some cases, set new ones for their retirement years. It’s important to make sure that those new goals are still in sync with their level of risk tolerance.
Many investors who are in or are nearing retirement still have a strong appetite for risk. However, they are at a time in their life when their tolerance for risk is much less. This is because, after years of growing their portfolio, they are now going to have to start living off of it. This flight towards safety, however, does not mean there should be no risk tolerance at all. In fact, one of the common scenarios facing these investors is that they get too conservative and their portfolio performance does not align with the lifestyle they want to live in their retirement.
How do I determine my level of risk tolerance?
If you are working with an investment advisor, they will have some form of assessment for you to take that will help determine your level of risk tolerance. If you're investing on your own, many investment websites will have some form of a questionnaire to help you assess your level of risk tolerance.
You will probably be asked questions like:
- What is your current age?
- At what age do you plan to retire?
These will be followed up with questions that may ask you to rank statements on a scale of Strongly Disagree to Strongly Agree. These statements would be similar to:
- I am willing to accept an above-average risk to get above-average returns on my investments.
- I would not be tempted to sell my investments if they lose money over the course of a year.
- I feel anxious about investing in the stock market.
- I know a lot about investing and the economy.
The results you get are just a guideline. You may be labeled as having a moderate risk tolerance, but still, wish to be more aggressive. But tools like this force you to think about how comfortable you are with investing and potentially losing money.
What are some strategies for managing my risk tolerance?
One of the most important ways to manage your risk tolerance is by diversifying your investments. The principle behind diversification is that different asset classes (stocks, bonds, cash, etc.) move in different directions at different times. By putting your money in different asset classes your portfolio should always be protected no matter what a specific asset class is doing at a particular time.
A step above using simple diversification to manage risk tolerance is to adopt, and follow, an asset allocation strategy. With asset allocation, you designate a specific percentage of your portfolio for each asset class and you maintain that mix. Since stocks and bonds usually move in opposite directions, when stocks are up your asset allocation mix will start to get overweighted to stocks. To correct this, you simply take some profit from the stocks that are performing well and move that money into bonds. This is called rebalancing.
Maintaining an asset allocation strategy requires discipline. It does mean that you may be selling shares of a stock that is surging, which will make you feel like you’re missing out on a potential gain. However, that should be balanced out by the peace of mind that you’ll have from knowing that your portfolio is at a manageable level of risk.
Mutual funds are a great option for managing risk tolerance because, by design, they spread the individual risk that is inherent in any security across a basket of stocks that align with the fund’s objective.
The bottom line on risk tolerance
Investing is about managing risk and reward. No investment is without some degree of risk. Any investor that purchases securities such as stocks, bonds, mutual funds or exchange-traded funds (ETFs) should clearly understand that they could lose some or all of their initial investment.
The most conservative investor needs to understand that a certain amount of pain is necessary for their portfolio to grow. Think of it like a rose bush that requires periodic pruning to allow new roses to bloom. Sometimes stocks have to go down in order to move to new heights. If they carefully invest in higher-risk assets like small-cap growth stocks and small-cap mutual funds, they are giving their portfolio a greater opportunity for better returns if they give it enough time. Playing it safe with low-risk assets may not be sufficient for helping them meet their goals.
In contrast, aggressive investors would do well to remember the mantra: pigs get fat; hogs get slaughtered. Many a portfolio has gone up in flames because investors threw everything they had at the latest trend or tried to time the market. By being disciplined enough to stick to a level of asset allocation and rebalancing your portfolio on a regular basis, these investors can continue to be aggressive while ensuring that they are sheltering their portfolio from unnecessary risk.