Investing is personal—just like your background, ambitions, and financial goals. That’s why understanding your risk tolerance is a critical step in building a portfolio that works for you. Your risk tolerance indicates how much risk you’re comfortable taking on in your investments and how much you can afford to lose without losing sleep.

Risk tolerance can be broken into two key parts: willingness to take risks (your personal attitude toward risk) and ability to take risks (based on your financial situation). Let’s explore both to help you figure out where you stand.

Willingness to Take Risks: Managing Your Emotions

Some parts of risk tolerance are psychological—this is your willingness to take on risk. Are you someone that can coolly slap $1,000 down on the craps table, ready to (literally) roll the dice and accept that you may walk away with nothing? Or do you drive at or below the speed limit to play it safe, regardless of how impatient the drivers behind you are? Neither personality is better or worse when it comes to investing; it’s simply about recognizing how much you can emotionally handle.

In investment terms, being risk-averse means you prefer more stable, predictable returns, even if they’re smaller. Interestingly, most humans are risk-averse so no shame here. Riskier investors, on the other hand, are comfortable with wider swings—chasing higher potential returns but accepting the fact that they might experience greater losses.

Understanding your personal willingness to take risks is important because it shapes how you’ll react when the market dips. If you panic-sell every time the stock market drops, you may end up locking in losses that could have been avoided if you had stayed the course. On the other hand, if you’re comfortable riding out market volatility for the possibility of bigger gains, then you might have a higher tolerance for risk.

Ability to Take Risks: Assess Your Life

While your willingness to take risks is within your control, your ability to take risks is more about the facts of your life. How much risk you can afford to take depends on factors like your age, income, net worth, financial goals, and how long you can invest without needing the money.

If you’re young and just starting your career, you likely have a long time horizon and can afford to invest in riskier assets, like stocks, because you have years to ride out market fluctuations. On the flip side, if you’re approaching retirement and will soon need to start withdrawing money from your investments, you should dial down the risk. At that point, stability and preservation of your capital become more important than high returns. You may be the type that wants to buy the riskiest stock since Gamestop, but if you’re 70 years old and need retirement income, that’s just not something most financial advisors would recommend. Conversely, cash under the mattress may make you feel warm and fuzzy, but if you’re in your 20’s, you’d be better suited putting that money into something that will actually produce returns.

Here are some factors that determine your ability to take on risk:

• Age: Younger investors can generally afford more risk since they have time to recover from losses.
• Investment timeline: The longer you can keep your money invested, the more risk you can take. Shorter time frames call for more conservative investments.
• Income and cash needs: If you have a stable income and don’t need to touch your investments for a while, you can likely afford to take on more risk.
• Net wealth: If you have a solid financial cushion, you’re in a better position to handle risk. But if every dollar counts, you’ll want to be more cautious.

The main takeaway? Even if you want to invest in high-risk, high-reward assets like volatile stocks, your financial situation may not allow for it. You need to balance both your willingness and ability to take on risk.

Volatility: Measuring the Risk in Your Investments

Volatility is the degree of magnitude and rate at which an investment or portfolio fluctuates. It helps determine how risky an investment is. It measures the degree of ups and downs in the price of an asset over time. The more volatile an asset, the more its price fluctuates—sometimes dramatically in a short period.

A moody person can experience the highest of highs but also the lowest of lows (more volatile). An even-keeled person would tend to be much more calm and chill (less volatile). When constructing a portfolio, much like assembling a cohort of individuals, it’s better to have a good mix of both to keep the group from being neither too extra hyperactive nor excruciatingly boring. Stocks, especially those of smaller or newer companies, tend to be more volatile, while bonds or established blue-chip stocks are typically less volatile.

A lot of math is used in calculating investment volatility, but the takeaway is straightforward. Investors with a higher risk tolerance are usually more comfortable with volatile investments because they can handle the price swings and potential for loss. For more conservative investors, low-volatility investments are preferred to help keep their portfolio stable and minimize stress.

Expected Returns and Risk

One of the most important things to understand about investing is that higher returns generally come with higher risks. This is where expected return comes into play. Expected return is an estimate of how much you might make (or lose) on an investment based on historical data and financial projections.

Higher-risk investments, like stocks in emerging tech companies, might offer greater potential returns, but they also come with a bigger chance of losing money. On the flip side, safer investments, like government bonds, offer smaller returns but with much less risk.

When constructing your portfolio, you have to ask yourself: Are you comfortable with the possibility of large losses for the chance at large gains? Or would you prefer slow, steady growth with less risk of losing money? Your answer helps determine the balance of assets in your portfolio.

Find Your Balance!

Understanding your risk tolerance is the first step toward smart investing. It’s not just about how much risk you want to take—it’s about how much risk you can take. A young investor with a high willingness to take risks may still need to limit their exposure to volatile investments if they have a short-term goal, like buying a house in a few years. On the other hand, someone nearing retirement may be more risk-averse but could still benefit from some exposure to higher-risk assets to avoid losing out to inflation.

As your investment advisor, our job is to help you navigate these decisions. Whether you’re eager to maximize returns or want to protect your savings, we’ll help find the right mix of investments that match your personal risk tolerance and financial goals.