How to Determine Your Risk Tolerance Level

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.

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.

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.

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.

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.

Let's say that at the beginning of 1970 you decided to invest $10,000 into one of the three hypothetical asset-allocation models show below. And every year until the end of 2016, you rebalanced your portfolio to make sure you still had the right percentage of stocks, bond and cash. The most aggressive portfolio would have climbed to $892,028, the moderate portfolio would have been valued at $676,126 and the most conservative portfolio would have been worth $389,519.

Such wide-ranging results show how taking on extra investment risk can potentially provide a bigger payoff than playing it safe. But more aggressive choices will also put your risk tolerance to the test. Consider what happened to each of these portfolios when times got tough:

• The aggressive portfolio had the highest annualized return but was also twice as volatile as the conservative portfolio. It also skidded more than 44% in its biggest decline during the period.
• The biggest annual decline for the moderate portfolio, with a slightly less volatile mix of assets, was approximately 32%.
• The most conservative portfolio dipped just 14% in its largest decline. However, it also achieved the lowest annualized return over the period.

The closer you get to when you want to access your money, the more those potential setbacks can sting. If you had taken your money out of one of the riskier portfolios after it tumbled—either because you needed the cash, you "followed the herd" of sellers who drove prices down or you simply couldn't stand stomach the pain of losing so much—your returns during that 47-year period would have suffered significantly.

By contrast, when you accurately gauge your limits for investment risk, and then invest in a portfolio that reflects your risk tolerance, time horizon and personal circumstances, you're one step closer to achieving your financial goals.