When you hear "risk" related to your finances, how does it make you feel? Do you see an opportunity for great returns? Do you imagine the "thrill" of investing? Do you become worried that you'll be left with nothing? Do you believe that risk is just an essential part of the investing process?
To better understand your risk tolerance, ask yourself questions like these and think about your behavioral tendencies—such as what actions you'd likely take after experiencing a significant investment loss or what decisions you've made in the past when the markets took a turn for the worse.
Providing an honest answer to these type of questions—and then taking on a commensurate level of investment risk—could help you build a portfolio that you'll stick with, even when market activity makes you nervous.
What is risk tolerance?
Simply put, risk tolerance is the level of risk an investor is willing to take. But being able to accurately gauge your appetite for risk can be tricky. Risk can mean opportunity, excitement or a shot at big gains—a "you have to be in it to win it" mindset. But risk is also about tolerating the potential for losses, the ability to withstand market swings and the inability to predict what's ahead.
In fact, behavioral scientists say "loss aversion"—essentially, that the fear of loss can play a bigger role in decision-making than the anticipation of gains—can color your approach to risk. Since risk tolerance is determined by your comfort level with uncertainty, you may not become aware of your appetite for risk until faced with a potential loss.
Risk tolerance vs. risk capacity
Though similar in name, your risk capacity and risk tolerance are generally independent of each other.
Your risk capacity, or how much investment risk you are able to take on, is determined by your individual financial situation. Unlike risk tolerance, which might not change over the course of your life, risk capacity is more flexible and changes depending on your personal and financial goals—and your timeline for achieving them.
If you have a mortgage, your own business, kids approaching college or elderly parents who depend on you financially, you may be less likely to comfortably ride out a bear market (given your income needs) than if you're single and not holding any major financial obligations.
A financial shock—like job loss, an accident that comes with expensive medical bills or even a windfall—can also affect your investment decisions by altering the amount of risk you're able to afford.
Keeping in line with your goals
When determining your risk tolerance, it's also important to understand your goals so you don't make a costly mistake. Your time horizon, or when you plan to withdraw the money you've invested, can greatly influence your approach to risk.
Your time horizon depends on what you're saving for, when you expect to begin withdrawing the money and how long you need that money to last. Goals like saving for college or retirement have longer time horizons than saving for a vacation or a down payment on a house. In general, the longer your time horizon, the more risk you can assume because you have more time to recover from a loss. As you near your goal, you may want to reduce your risk and focus more on preserving what you have—rather than risking major losses at the worst possible time.
One way to fine-tune your strategy is by dividing your investments into buckets, each with a separate goal. For example, a bucket created strictly for growth and income can be invested more aggressively than one that is set aside as an emergency fund.
Translating risk tolerance into an investment strategy
Completing the Schwab Intelligent Portfolios® Investor Profile Questionnaire can help you assess your individual risk tolerance. Here, honesty is definitely the best policy—you want the asset allocation mix in your recommended portfolio to most accurately reflect your true tolerance for risk.
Once you know where you fall along the risk spectrum, the next step is to become familiar with typical performance data for your portfolio. The more you know about what you can expect, the smaller the chance that you will react emotionally when times get tough.
Smart investors consider both risk and return. Investments with higher expected returns (and higher volatility), like stocks, tend to be riskier than a more conservative portfolio that is made up of less volatile investments, like bonds and cash. However, even the most conservative portfolio can experience short-term losses due to ever-changing market conditions. This is why it's important to have a diversified portfolio that includes a wide variety of investment options.
Reviewing your risk profile is easy with Schwab Intelligent Portfolios. To do so, after logging into your account, select the "Settings" tab, then "Review Profile." After reviewing your Investment Profile Summary, you can select the "Edit Profile" link to make changes.
Please read the Schwab Intelligent Portfolios Solutions disclosure brochures for important information, pricing, and disclosures relating to Schwab Intelligent Portfolios and Schwab Intelligent Portfolios Premium programs.
Schwab Intelligent Portfolios® and Schwab Intelligent Portfolios Premium® are made available through Charles Schwab & Co., Inc. ("Schwab"), a dually registered investment adviser and broker-dealer. Portfolio management services are provided by Charles Schwab Investment Management, Inc. ("CSIM"). Schwab and CSIM are subsidiaries of The Charles Schwab Corporation.
Diversification, asset allocation, automatic investing and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets.