What is risk tolerance in investing?
It’s important to understand how much risk you’re willing to take before investing.
All investments come with risk. Generally, the higher the potential return an investmentInvestment An item of value you buy to get income or to grow in value.+ read full definition offers, the higher the risk. But there is no guarantee higher risk investments will pay off with higher growth or dividends.
That’s why it’s important to know how much risk you are comfortable with. That’s called your risk tolerance.
On this page we answer
- What is risk tolerance?
- How much risk are you able to handle?
- How much risk are you willing to handle?
- What might a financial advisor ask about your risk tolerance?
- How can you re-assess your risk tolerance?
- What are 3 things to consider about your risk tolerance?
What is risk tolerance?
Risk tolerance is both your ability and willingness to accept an investment outcome, even if it doesn’t produce the expected results.
Risk tolerance is a balancing act. Most people want their portfolioPortfolio All the different investments that an individual or organization holds. May include stocks, bonds and mutual funds.+ read full definition to have the highest return, given the highest risk they can accept.
If you have a low risk tolerance, you will likely choose a safer, lower risk portfolio with lower potential returns.
If you have a high risk tolerance, you will likely choose a riskier portfolio with a higher potential return.
Risk tolerance involves thinking about two questions:
- How much risk are you able to handle?
- How much risk are you willing to handle?
While these questions might sound similar, they are quite different.
Your risk tolerance includes both your ability and willingness to tolerate risk.
How much risk are you able to handle?
Would you be okay financially if you lost more than expected in a risky investment? Or would an unexpected investment loss force you to reduce your standard of living? Your answer will help you understand how much risk you can handle, financially.
Your ability to tolerate risk depends on your wealth. Wealth includes your financial wealth, such as investments and savings. And it also includes your human capitalHuman capital Human capital is someone’s ability to generate income from work.+ read full definition — your ability to earn income from work — which can help cover investment losses.
Wealthier investors can usually take on more financial risk than those with more limited financial resources. Picture these two different scenarios:
- A young, well-educated investor, with no outstanding debtDebt Money that you have borrowed. You must repay the loan, with interest, by a set date.+ read full definition, who expects to work for 40 years before retiring. This investor has the time and income to make up for losses, so she feels comfortable investing $10,000 in a higher-risk portfolio.
- A retired investor with a limited monthly budgetBudget A monthly or yearly estimated plan for spending and saving. You work it out based on your income and expenses.+ read full definition for expenses. This investor cannot afford a loss of $10,000 without risking his monthly income that’s needed to cover his expenses. He does not have the time or income to earn back losses. And his current investment portfolio covers just a little more than his monthly spending needs.
How much risk are you willing to handle?
Your willingness to tolerate risk introduces the emotional side of investing. It is also called your psychological risk tolerance.
If your portfolio causes you stress, you may have investments with more risk than you are willing to tolerate. To lessen your stress, you might consider making your portfolio less risky.
It is easy to overestimate your willingness to tolerate risk. Think about the last time you dealt with an investment loss — how did you react? If you had trouble accepting the loss, or perhaps lost sleep over it, consider reducing the risk of your portfolio.
Risk-taking varies amongst Canadian investors. Whether you identify as a lower-risk or higher-risk investor, you are not alone. Risk-taking behaviour is influenced by many things, including past investment experience, investing knowledge, time horizonTime horizon The length of time that you plan to hold an investment before you sell it. This may be a brief period of time or span as long as decades, depending on your financial goals.+ read full definition, and beliefs about the future.
Both your ability and willingness to tolerate risk are connected. Consider both when you are making a new investing decision.
Research shows that overconfidence can often lead to higher levels of risk taking. Learn more about overconfidence and how this behavioural bias might influence your portfolio decisions.
What might a financial advisor ask about your risk tolerance?
A financial advisor will ask you questions to understand your investment needs, objectives and risk tolerance. They may ask:
- When do you expect you will need the money you are investing?
- Do you have any big purchases you’re saving up for (e.g., a car or a house)?
- How would you respond if the value of your portfolio dropped by 20%?
- What is the level of your investment knowledge?
How can you re-assess your risk tolerance?
Your risk tolerance may shift as your financial circumstances change and your personal needs evolve. Getting married, having a child, or preparing to retire can make you rethink your risk tolerance and overall investment goals.
Be sure to regularly revisit your risk tolerance decisions. Let you advisor know if there are changes in your life that may affect your risk tolerance. If you’re managing your portfolio on your own, assess your portfolio every year to ensure you’re still comfortable with the risks you’re taking.
What are 3 things to consider about your risk tolerance?
1. Life changes
Your risk tolerance will fluctuate as your life changes. Losing a job, starting a business, growing your family, or receiving an inheritanceInheritance Property, money, titles, or debts that pass to you after someone’s death.+ read full definition may influence how much risk you may be willing to accept.
These events might be planned, but sometimes life changes quickly. An emergency can also suddenly change your financial circumstances and risk profile.
2. Time horizon
In general, the longer your investing time frame, the more risk you can afford. That’s because you have more time to recover if an investment doesn’t perform as expected.
When you land your first full-time job and start saving for retirement, you may be able to accept more risk because you won’t need the money for decades. While a riskier strategy can mean greater volatilityVolatility The rate at which the price of a security increases or decreases for a given set of returns. A stock price that changes quickly and by a lot is more volatile. Volatility can be measured using standard deviation and beta.+ read full definition, over time, you may benefitBenefit Money, goods, or services that you get from your workplace or from a government program such as the Canada Pension Plan.+ read full definition from stronger returns.
Higher investment risk may sometimes be appropriate for your investing goals, but it may not be a prudent choice for all your savings. If you think you’ll need the money within the next few years, consider adopting a more conservative investment strategy.
3. Personal preference
It’s one thing to tell an advisor you are comfortable with risk and volatility in your portfolio but experiencing it can be quite different. A sudden loss can lead to strong emotions and influence your investing decisions. Managing emotions can be challenging. But emotionally driven decisions can harm your portfolio.
Two people in similar situations may have very different risk tolerances. It’s important to have a portfolio that matches your goals and appetite for risk. Ideally, you want to adopt a strategy that you can be comfortable with over the long termTerm The period of time that a contract covers. Also, the period of time that an investment pays a set rate of interest.+ read full definition.
Our individual behaviours are prone to bias. That can make financial decisions challenging. Try our behavioural bias checker to understand more about your financial decision making.
Knowing your risk tolerance includes:
- Understanding your investing personality and how much money you’re comfortable losing.
- Learning about insights that might better explain your investment decision.
- Not feeling pressured into an investment if you don’t feel comfortable.
- Not adjusting your portfolio based on an emotional response — take the time to assess your risk tolerance before making a change.
- Being aware that your risk tolerance may change based on changes in your life, your time horizon, and personal preferences.
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