One of the most critical aspects of a successful investment plan is risk tolerance.

By knowing your risk tolerance, you can better understand your investment strategy and what to expect during market drawdowns.

What is risk tolerance?

Your risk tolerance in investing is how much risk you are willing to take in exchange for potential future gains.

Additionally, it measures your willingness to accept potential losses in your investment portfolio.

Risk tolerance vs. time horizon

Risk tolerance and time horizon are key factors in investing, but both serve two distinct purposes.

While risk tolerance is how much risk you are willing to take to achieve a higher expected return, time horizon is the amount of time you plan to make an investment until you need access to the money

Basically, the difference comes down to how much risk you are willing to take versus how much risk you are able to take.

Striking a balance between both is key and will help you maintain growth potential as well as peace of mind.

Why does risk tolerance matter?

Aligning your investments with your risk tolerance is important for building a successful investment plan.

Having an appropriate risk tolerance helps ensure that your investment portfolio matches your goals and objectives, time horizon, and willingness to stay invested during good and bad market cycles.

Other benefits of knowing your risk tolerance include:

Supporting Personalized Planning

Everyone’s financial plan is unique and will always differ from the person sitting next to them. What works for a 30-year-old professional might not be the best choice for someone three years from retirement.

Preventing Emotional Decision-Making

Having an appropriate risk tolerance will help keep you invested and ensure that your portfolio is not carrying more risk than you’re comfortable with.

Guiding Asset Allocation

Assessing your risk tolerance will help determine your equity and fixed income allocation.

For example, someone with a higher risk tolerance could have more stock allocation. Someone with a lower risk tolerance would have more fixed income allocations.

Optimizing Potential Investment Returns

Having the right risk tolerance relative to your desired time horizon will ensure your investment returns are appropriate and sustainable for your goals over time.

How to determine your risk tolerance

When assessing your risk tolerance, you will want to walk through these five steps.

1. Review Your Investment Goals

Reviewing your investment goals on an annual basis will help ensure that your current investment strategy is still the right plan for you.

2. Reflect on Previous Market Cycles

How did you react during past market drawdowns like in 2020 and 2022?

Did you stay invested, feel anxious, or desire to make a change?

Having a high risk tolerance is great when markets are up, but it is even more important when markets are down.

3. Understand Your Time Horizon

If you are investing for a retirement that is 20 years away, you can afford more volatility than if your goal is three to five years out.

4. Consider Your Income Stability and Life Stage

A steady job and a healthy emergency fund? A higher risk appetite is something to consider.

Upcoming retirement? A more cautious approach may be better.

5. Understand What You Are Saving For

New car? House? Retirement? All of these savings goals will require a different investment approach.

For example, if you are saving for a major purchase 10+ years from now, investing might be a great idea.

However, if you plan on purchasing a home within the next one or two years, it may be best to leave your savings in a cash-equivalent investment to ensure your money is there when it’s needed.

Tailoring risk tolerance to your personal financial plan

Once you know your risk tolerance and understand what you are saving for, it’s time to align your investments accordingly.

Remember: you can also rebalance over time as your situation evolves.

• Short-term goals
  • Generally, one to three years
  • Immediate time horizon
  • Consider low-risk options like cash and bonds
• Medium-term goals
  • Three to 10 years
  • Intermediate time horizon
  • Consider a managed mix of both stock and bond exposure
• Long-term goals
  • 10+ years
  • Long time horizon
  • Ability to have maximum equity exposure

We can answer your risk tolerance questions

There is no one-size-fits-all approach to risk tolerance in investing. That’s why it is important to work with a financial advisor to make sure your financial plan is tailored specifically to your goals.

If you have questions or would like to visit about your risk tolerance, reach out to me.  I look forward to helping you plan for a successful financial future!