What’s your likely response to a sudden 10% drop in the value of an investment? Would you sell all or some of your shares? Do nothing? Would you ever consider buying more?
Your answers to questions like these could provide important insights into your true risk tolerance, says Rob Williams, vice president of financial planning and retirement income at the Schwab Center for Financial Research.
Risk tolerance is an essential consideration when determining how to construct and maintain your portfolio over time. Unfortunately, investors aren’t always the best judges of their own appetites for risk, Rob notes.
For one thing, many people don’t consider the difference between risk tolerance and risk capacity, he says. Understanding how these two qualities differ—and how they interact in your life—can help you maintain an investment strategy that may enable you to better achieve your goals.
In the most basic sense, risk tolerance is your ability to stomach wide market swings in exchange for potential higher returns in the future.
But being able to accurately gauge your taste for risk can be tricky, Rob says. “When the market is doing well, you may think your risk tolerance is high. But when the market falls, you forget about that and your appetite for risk drops.” This is basic human nature, a phenomenon that psychologists refer to as loss aversion—the concept that losses trigger a greater emotional impact than equivalent gains.
That’s why investors often end up buying high and selling low—never a good strategy for success.
To get a better understanding of your ability to tolerate risk, it helps to look more broadly at the type of person you are. In fact, risk tolerance can be more of a life-long behavioral preference and may not change much over your lifetime, says Rob. “Risk tolerance is a personality trait, similar to being an extrovert or an introvert,” he says.
Your risk tolerance may not change much over time.
That said, a person’s risk tolerance may vary across different areas of his or her life. Risk-taking behavior is divided into different domains, and there are no correlations between them. For example, some people who enjoy high-risk hobbies, such as skiing or rock climbing, may prefer very conservative investments. It depends on the person. And risk tolerance can also vary by gender. On average, men may have a higher risk tolerance than their female partners.
What does shift over time is your capacity to take on financial risk—that is, your ability to withstand a financial shock. Your risk capacity can be influenced by a variety of financial factors throughout your life, including loss of a job, saving for your children’s education or a health crisis that leads to unexpected medical bills—changes that will likely lead you to revisit both personal and financial goals and your timeline for achieving them.
Thus, it’s important to understand how your capacity and your tolerance for financial risk may interact, Rob notes.
“Can” versus “should”
A high tolerance for risk doesn’t mean you should take on more risk than necessary to achieve specific goals. Consider your time horizon. “If you have a goal of sending your kids to college, and the time horizon before they start is 15 years or more from now, it’s likely that you’d have time to recover from volatility in the market—so you could take on more risk,” Rob says. “But as you move closer to your goal, your risk capacity may change because you may not have time to recover from a market drop.”
Your level of wealth could also impact your capacity for risk. It may seem obvious that the more you’ve accumulated, the more easily you could weather a downturn in your portfolio without it affecting your goals or lifestyle. And while that’s perhaps true when you still have a long time horizon, you may eventually want to think about protecting your wealth for future generations, Rob notes.
Charles Schwab’s Investor Profile Questionnaire can help you understand your tolerance for risk—and also guide you in determining your risk capacity when constructing a portfolio. Rob recommends revisiting the questionnaire once a year when reviewing your investments and reconsidering your asset allocation, given how your life may have changed over the past 12 months. Ask yourself whether your goals, priorities or time horizon have shifted.
Going through that exercise, you may find that you have a moderate level of risk tolerance but a different risk capacity for each goal.
For example, if you have an emergency fund, it’s hard to predict when you’re going to need that money—so it shouldn’t be invested aggressively, Rob says. If you’re saving for a down payment on your first home, your capacity for risk will depend on when you plan to make the purchase. In your retirement account, you should gradually reduce your risk profile as retirement nears, without eliminating risk altogether.
To manage different goals, Rob suggests dividing investments into multiple buckets with different allocations. If you’re someone who enjoys excitement in your portfolio, consider taking those extra risks in a separate account using assets that you can afford to lose, he says—in other words, where you have a greater risk capacity.