Risk tolerance

Risk is the uncertainty (variation) of an investment's return, which does not distinguish between a loss or a gain. However, investors usually think of risk as the possibility that their investments could lose money.

Risk tolerance is your emotional and psychological ability to endure investment losses during large market declines without selling or undue worry, such as losing sleep. To know whether a portfolio is right for your risk tolerance, you need to be brutally honest with yourself as you try to answer the question, "Will I sell during the next bear market?"

Risk tolerance defined
Author Rick Ferri defines risk tolerance as:

Bogleheads author William Bernstein uses risk tolerance in the sense of attitude toward risk. He suggests that investors can evaluate their risk tolerance based on how they reacted to the financial crisis during 2008 and early 2009:


 * Sold: low risk tolerance
 * Held steady: moderate risk tolerance
 * Bought more: high risk tolerance
 * Bought more and hoped for further declines: very high risk tolerance

You can adjust the level of risk in your portfolio by adjusting your asset allocation.

Why is risk tolerance important?
Risk tolerance is a key factor for creating your asset allocation (the percentage of stocks,  bonds, and cash or  cash equivalents) that will let you stay the course during inevitable market downturns.

Ability, willingness and need to take risk
Author Larry Swedroe defines asset allocation as "the process of investing assets in a manner reflecting one’s unique ability, willingness and need to take risk," with willingness referring to risk tolerance and whether you have the "fortitude and discipline" to stay with an allocation during market downturns.

Ability to take risk involves your investment time horizon, need for liquidity, stability of earned income, and your flexibility to adapt if you need a plan B.

Willingness to take risk is characterized as the eat well/sleep well trade-off. You need to take more risk for the possibility of higher expected returns (eat well). However, if you take more risk than you can handle emotionally, then it is likely that you will abandon your investment plans if your portfolio suffers big enough losses. So it is unwise for you to take so much risk that you will not sleep well during the inevitable stock market downturns.

Need to take risk is determined by the rate of return you need to achieve your financial objectives. If you decide to take more risk because of perceived "need", remember that taking extra risk could well backfire and lead to lower returns. Perhaps more importantly, once you have "won the game" by accumulating sufficient wealth, it is unwise to take more risk than you need, because the value of additional gains is much less important than the consequences of severe losses.

Why is risk tolerance difficult to determine?
Knowing your emotional tolerance for investment risk means knowing yourself and your unique goals and needs - and it is not easy.

Jason Zweig writes in his book on neuroscience, Your Money & Your Brain, that "... perception of investment risk is in constant flux, depending on your memories of past experiences, whether you are alone or part of a group, how familiar and controllable the risk feels to you, how it is described, and what mood you happen to be in at the moment."

Investors are often asked by financial advisors to take risk tolerance questionnaires intended to help determine how aggressive or conservative their investments should be. But Jane Bryant Quinn in her book, How to Make Your Money Last, calls the questionnaires "... generally bunk. You’ll lean toward more risk if stocks are going up, you’ve had a good day at the office and your shoes don’t pinch. If you’ve had a bad day because stocks went down and your unemployed child is moving in, you’ll suddenly feel more conservative."

Rick Ferri says some questionnaires that are worded well may be helpful, but "...overall they are not the answer to the asset allocation question. ... Finding a person’s maximum tolerance for risk takes a lot more than a questionnaire. It requires soul-searching. We tend to be brave in a bull market, and this means that it is not the ideal time to search for our risk tolerance. Soul-searching should be done in a bear market when we are not sure what is going to happen next."

Behavioral pitfalls
Understanding and avoiding behavioral pitfalls has a greater final impact on your investing success than any other factor. Because emotions and subsequent behavioral pitfalls often lead to miscalculating risk tolerance and asset allocation, you need to be aware of behavioral pitfalls before making asset allocation decisions.

An important pitfall to be aware of is loss aversion, the emotional tendency to strongly prefer avoiding losses over acquiring gains. As an example, loss aversion implies that if we lose $100, our emotional pain much larger than the satisfaction we would feel from receiving $100. Common indications include checking your portfolio on an almost daily basis, selling funds before you intended to lock in profits, or selling when you did not intend to in order to avoid further losses.