How to measure your tolerance for risk

IF YOU’VE EVER WONDERED how you’d deal with a challenging market, 2022 has likely put that to the test. Both stocks and bonds have incurred historic sell-offs, shaking many investors’ faith in their investment strategy and financial futures.

“Markets can change very quickly and unexpectedly, and as investors, we cannot control that,” says Niladri Mukherjee, head of CIO Portfolio Strategy, Chief Investment Office, Merrill and Bank of America Private Bank. “What we can control is how we manage risk.”

The key is understanding your comfort with risk before a crisis hits, so you’re less tempted to pull out of the market when volatility strikes and miss out on potential gains when it recovers.

The following questions can help guide you in understanding how much risk you can tolerate — and afford — in any market.

How much risk can you take on and still sleep at night?

This year's development as well as the dramatic drop in stock prices triggered by the coronavirus in early 2020 and the economic shutdown that followed can provide a useful gauge in determining how much you’re comfortable keeping in riskier assets like stocks versus less risky investments, like high-quality bonds and cash. “The goal is to understand how much risk you truly can withstand and still sleep at night,” says Mukherjee. That’s your “risk tolerance.”

You’ll also want to determine how much risk you can afford to take with your investments without jeopardizing your goals. Consider things like your income and overall financial resources, along with how much time you have for reaching your goals.

For example, an investor who is within a few years of retirement might avoid putting a large percentage of her net worth into high-risk investments, because the time frame for when she’ll need to access them is shorter than someone with several decades until retirement. Your advisor can work with you to help you get a solid grasp of both your tolerance and capacity for risk.

By sticking within your comfort zone, you’ll be less tempted to abandon the markets when they get volatile — a decision that could hurt your investment returns over time.

As the graphic below illustrates, an investor who pulled out of the stock market during the Great Recession of 2008–2009 and re-invested just one year later would have missed the initial market rebound — significantly reducing their potential returns over the next decade. And someone who exited the stock market and moved their investments into cash would have risked not realizing any returns in the following years.

Another useful strategy, especially if you’re young or new to investing, can be to make a commitment to invest a certain amount on a predetermined basis — known as dollar-cost averaging. “It can help reduce the urge to try to time the market,” notes Mukherjee, “or make knee-jerk reactions when markets get turbulent.” Keep in mind that dollar-cost averaging cannot guarantee a profit or prevent a loss. And because an investment plan of this nature involves continually investing in securities regardless of fluctuating price levels, you should consider whether you’d be willing to continue purchasing during periods of high or low prices.

What’s the time frame for your various goals?

It’s often helpful to think about the amount of time you have to reach each of your goals, as that will help inform the investment choices you make. Funds to cover unexpected expenses like large home repairs or medical bills or to weather a layoff should be in cash or a highly liquid, low-risk investment such as short-term bonds. For near-term goals that are five or so years away, such as a home down payment, you might opt for conservative investments that typically aren’t as volatile as stocks.  

When it comes to long-term goals like retirement, however, being too conservative increases the risk that your portfolio might not grow at a pace that keeps up with inflation. In the decade prior to the pandemic inflation has been low — generally less than 2% a year. But even a 2% annualized inflation rate means that what costs you $100 today will cost nearly $150 in 20 years, and the purchasing power of your current savings will fall accordingly.

Planning around the corrosive effect of inflation is especially important for your retirement security, given that a nonsmoker who reaches age 65 in average health has a more than 50% probability of still being alive into their mid-80s, and living into one’s 90s is no longer that uncommon.¹ So if you have many years before retirement, you could consider a larger allocation to equities that offer greater potential for growth for your longer-term goals, Mukherjee suggests.

You also could consider alternative investments such as private equity and real estate funds if appropriate for your situation. They are often riskier — and less liquid than traditional assets like stocks — but may offer the possibility of higher returns. Your advisor can help determine if these types of investments are appropriate for your circumstances.

Are there any special situations that might affect your ability to take risk?

The stability of your income might affect how much risk you can take with your investments. Similarly, if you own your own business or have a lot of equity in your employer’s company, you may want to take less risk with your outside investments as a result.

Also take into account significant life changes, such as marriage, birth of children (and grandchildren), a job loss or new job. “Your goals and therefore your time horizons for individual goals and risk tolerance are dynamic,” says Mukherjee. “If building more near-term security is a priority, you may want to increase your lower-risk investments for a period, which may entail scaling back riskier assets designated for longer-term goals, such as saving for future college costs.”

Working through all those moving pieces can help you build an overarching allocation of different types of stocks and bonds, periodically rebalanced to ensure that it doesn't stray too far from your predetermined allocation.