Choosing Your Risk Level

The plain answer

Your risk level should reflect three separate questions:

• Ability: Can your finances and timeline withstand losses?
• Willingness: Can you stay invested when your portfolio falls?
• Need: How much risk must you take to have a reasonable chance of reaching the goal?

Use the most limiting answer. A long timeline does not make an aggressive portfolio appropriate if a large decline would cause you to sell. High comfort with risk does not make it safe to invest near-term spending money in stocks. A goal that is already well funded may not require taking the maximum risk you can tolerate.

Risk is not a personality score. It is a constraint on how you build and maintain a portfolio.

How it actually works

Ability to take risk comes from your circumstances. Longer timelines, flexible spending, stable income, strong emergency savings, and goals that can be delayed generally increase your ability to accept market losses. Short timelines, required withdrawals, unstable income, debt pressure, and goals with fixed dates reduce it.

Willingness to take risk is behavioral. Imagine seeing your portfolio fall by 20, 30, or 40 percent while alarming news continues for months. Your useful risk tolerance is not what feels comfortable during a rising market. It is the level at which you can keep following the plan during a decline.

Need to take risk depends on the gap between your resources and your goal. You may need more growth if contributions alone are unlikely to fund the goal. But increasing risk is not always a sound solution. Saving more, spending less, delaying the goal, or changing the goal may be more dependable than relying on higher returns.

These three factors lead to an asset allocation, such as a mix of stocks and bonds. Stocks offer higher expected long-term growth with larger and less predictable losses. Bonds usually provide lower expected returns with greater stability. Learn how the mix works in Asset Allocation and why return and risk are connected in Risk and Return.

What this means for you

Start with the goal. Write down when you expect to use the money, whether that date is flexible, and how much of the goal is essential. Then consider how a major market decline would affect both the goal and your behavior.

Choose an allocation you could continue holding through a severe downturn. If the projected loss would make you sell, miss necessary spending, or lose sleep for months, reduce the risk before the decline occurs. If short-term losses would not affect the goal and you can remain disciplined, a higher stock allocation may be reasonable.

Revisit your risk level when your life changes, not whenever markets become exciting or frightening. A shorter timeline, approaching withdrawals, job changes, new obligations, or a better-funded goal can all justify an allocation change. Market predictions are a weak reason to change a long-term plan.

Common mistakes

• Using age as the only input. Timeline matters, but income, flexibility, savings, and goals matter too.
• Confusing recent calm with high risk tolerance. Your response during an actual loss is more informative.
• Taking more risk because the goal is underfunded without first considering higher contributions or a revised goal.
• Choosing an aggressive allocation based on expected returns while ignoring the losses required to pursue them.
• Becoming conservative after markets fall and aggressive after they rise.
• Treating a questionnaire result as permanent. Your circumstances and goals can change.
• Mixing money for different timelines into one risk decision. Each goal may need its own allocation.

Related pages

• Asset Allocation
• Risk and Return
• When Bonds Make Sense