Knowing Your Risk Tolerance Is Key to Smart Investing

Building an investment portfolio requires careful thought, strategizing and diversification. But you can't build a workable portfolio until you know your risk tolerance. 

Investment risk tolerance is how much market volatility you're comfortable exposing your investments to. Investments fluctuate in value with the market, which means you'll probably need to weather recessions and periods of uncertainty over time. Generally speaking, higher-risk investments can yield greater returns—but they can also mean bigger losses. Lower-risk investments may not generate headline-grabbing returns, but they're often more consistent and reliable.

Ideally, your portfolio will include a diverse mix of investments so your risk is spread across several categories. Determining how much risk you're willing to take on is essential in creating a portfolio you feel comfortable with and confident in.

Understand your risk capacity

Before deciding your risk tolerance, it's a good idea to determine your risk capacity. This refers to how much money you can afford to risk in the market, as opposed to how comfortable you are with risk. 

For example, if you're about to have a baby or your spouse is starting a new business, it might not be the best time to go all-in on high-risk investments. On the other hand, if you've just received a large inheritance and are otherwise financially comfortable, you might be willing to take on more risk. Risk capacity comes down to ensuring that you've funded your priority expenses and savings accounts before entering into investments that may take years to show returns.

Know when you'll need the money

People often think about investment strategies in terms of age. One rule of thumb says that the older you are, the more conservative you'll want to be, because you'll need your investment earnings sooner in retirement. But that isn't always true. 

Someone who retires young, for example, may want to continue with an aggressive investment strategy to pursue higher returns. On the other hand, a younger investor might favor a more conservative strategy because they know they'll need the money in a few years when they plan to buy a house, have a child or start a business. 

When considering your risk tolerance, ask yourself when you expect to need the money, and let that inform your decision. The sooner you need it, the more sure of your investments you'll want to be.

Consider your dependents

If you're single or don't have children, you may be comfortable with higher-risk investments because you can weather the instability on your own. That may be especially true if you earn a good income and have substantial savings in addition to your investments. 

However, if you're using your investment portfolio to build your family's future—such as creating college funds or saving for early retirement—you may feel more comfortable with lower-risk investments. While you might not get as large of a return, the consistency of steady returns could bring more peace of mind and make it easier to track your financial goals.

Gauge your comfort with uncertainty

Investing requires a long-term mindset. You'll likely have to weather periods of market volatility while waiting for investments to grow. If the thought of watching the market dip makes you nervous, you may want to stick with perennially stable investments. These could include long-term certificates of deposit, savings bonds, mutual funds and high-yield savings accounts, along with stable stocks. 

If you're comfortable with a little more uncertainty, you may want to take a more aggressive approach. Volatility-friendly investors might consider venture capital opportunities, high-yield bonds or real estate investment trusts. Currency trading and emerging market investments can also be high-risk, high-reward opportunities.

Advisors can help determine your risk tolerance

Seeing returns from higher-risk investments requires a deep understanding of economic markets and shifting financial conditions. Whether you're risk-tolerant or risk-averse, you may want to work with a financial advisor or investment expert to decide which investments make the most sense for your goals. If you're unfamiliar with investing, an investing advisor can walk you through your options and develop a plan that suits your risk profile. 

A long-term investment strategy comes down to knowing your goals and knowing yourself. With that knowledge and the right expert advice on your side, you can build a portfolio that reflects who you are and what you hope to achieve.