Risky Business: what is risk tolerance and how could it impact your investment success?

You’ve paid off any burdensome debt, worked on establishing an emergency fund and decided how much money you can invest each month. Now what? It’s time to establish your risk tolerance, and what the safest investments you can make are to ensure a stable portfolio – and a stable financial future.

What is risk tolerance and how do I establish it?

Risk tolerance means how much uncertainty or market fluctuation you can handle without feeling stressed or making impulsive decisions. Imagine you’re at a theme park, and you’re evaluating what the biggest roller-coaster you can handle is without regretting getting on. That’s risk tolerance.

To establish your financial risk tolerance, you need to ask yourself three questions:

1. What is your financial timeline? If you aim to reach your goal within the next five years, you should bear less risk. If you are investing for retirement in forty years, you can bear more risk as you have more time to recover from market swings.
2. What is your goal? You may be investing to build up a house deposit – in this case you might choose a less risky portfolio. The greater the risk, the greater the reward – but accumulating the most amount of money possible may not be your end goal. Consider what it is you really want and how much risk you could handle in order to get there
3. What makes you feel comfortable? Your personality plays a part here. Are you more comfortable with a lower return but greater security? Or are you certain that you can stay the course during market crashes? The aim is to stay invested until you have reached the end of your timeline, not to panic and cash out. If you need a less risky strategy to achieve this, then congratulate yourself on your self-awareness. Knowing yourself is key to being a successful investor.

What does my risk tolerance mean for me? 

Whether you are a conservative risk-taker, a moderate risk-taker or an aggressive risk-taker, there will be an ideal way to balance your asset allocation.

Asset allocation is the percentage distribution between different assets, such as bonds (low risk) and stocks (higher risk). Stocks are the asset which will drive growth in your portfolio, but they can be volatile (read this article to find out which stocks make the safest investments). Bonds are a safer way to invest and will bring stability to your portfolio – but you need to remember that you simply will not make as much money if you allocate more money to bonds (everything you need to know about bonds is right here!).

Conservative investors

You are more likely to prioritise preserving your money and are comfortable accepting lower returns using low-risk investments such as bonds. You might consider allocating between 60-70% of your invested money to bonds and 30-40% to ETFs.

 Moderate investors

You strike a balance between risk and reward. You’re willing to accept some level of market volatility in exchange for the possibility of higher returns. You take a highly diversified approach to ensure that you achieve good returns on your investments, while managing your exposure. You probably want to look at a 60/40 split in favour of ETFs.

Aggressive investors

You are comfortable with a higher risk and plenty of volatility. You are hoping to maximise your returns and you know you can stomach market fluctuations. Your portfolio will be heavily weighted towards stocks, with minimal security through bonds. You may favour an allocation of 80% in ETFs and 20% in bonds. If you want to take a flutter on a specific stock or crypto, ensure that you gamble no more than 5% of your total portfolio in high-risk investments.

Honestly, I still don’t know…I like the idea of high rewards, but I don’t know if I could handle losing money in a crash

This is completely understandable, and probably how most of us feel. You can work around this by investing in a target-date fund. These funds automatically re-balance each year as you get closer to the target date, moving from a higher risk approach to the start to a more conservative strategy. They are a fantastic resource if you are setting up a fund for your children or focusing on retirement.

The only downsides with these is that they tend to be long-term funds, with penalties for withdrawing your money early, and that you will pay a higher management fee. BlackRock and Vanguard are both firms with good reputations – they would make a good starting points for enquiring about target-date funds.

Fearless Girls know that fearless investing does not mean jumping headfirst into a high-risk investing. In fact, you may be a conservative Fearless Girl with a logical strategy and a long-term goal. Real financial fearlessness is about understanding your investments and managing your risk in a way that makes you feel comfortable.

Have you calculated your risk tolerance? Let us know if you are an aggressive, moderate or conservative investor in the comments or tag us on Instagram @fearlessgirlfinance_