Risk tolerance enables you to trade-off some level of investment return for a smoother ride over time. A more conservative portfolio will go up less in the good times, but if well constructed will also fall less during the bad times.
There are several components to risk tolerance.
Step 1 - Determine Your Investment Time Horizon
One of the most important components of determining your risk tolerance, is knowing how soon you expect to need the money you're investing. If you need the money you've invested in a month's time, then you want to invest far more conservatively then if you won't need that money for another 30 years. That's because stocks can be very volatile in the short term. For example stocks can fall almost 20% in a month as they did in October 1987, but over a longer time period such as a decade it's very common for stock investments to double in value. Hence you need to pick a portfolio that fits your needs, it's risky to pick a heavily stock oriented portfolio if you'll need the money within months. Equally if you're investing for the long term, then putting money in cash is almost certainly wasteful. Certainly with cash there's little risk of a large fall in value, but also your investment is unlikely to rise in value and in fact inflation will erode it. Therefore, how long you are investing for is key for determining risk tolerance.
Step 2 - Consider Your Own Ability To Stomach Weak Markets
A second factor is your own ability to ride out bad markets. This can sound easy when you talk about it, since markets typically come back stronger after a period of sharp decline. However, when you are looking at lots of red ink across your portfolio it can be hard to stay the course. This can hurt your returns, for example during the 2008-9 market declines, many investors couldn't take the daily losses they saw in their portfolio and moved to cash. Unfortunately many never moved back into the market and, missed out on the S&P 500 tripling in value off the lows, in subsequent years. Hence it's important to have an allocation you have conviction in and losses you can stomach.
Step 3 - Consider Your Other Income Streams
A third important factor in risk tolerance is your own ability to earn money. If you have a steady, well paying job, you can probably take a little more risk, because you aren't relying on your investments as your only source of income. However, if you're retired and no longer earning an income from a job or business ownership, then you probably can take less risk with your investments, because if the market falls you have no way to find additional funds from income.
Step 4 - Find An Asset Allocation That Reflects Your Risk Tolerance
So when considering your risk tolerance consider your time horizon, ability to endure price declines and your ability to earn money outside of your investment portfolio. Once you have a sense of where you fall on the risk tolerance spectrum. FutureAdvisor can build a portfolio for you that aligns with your age and risk tolerance. Try it for free.