Risk tolerance is defined as an investor’s ability to handle declines in the value of his or her investment portfolio. Risk tolerance is a term that is commonly forgotten during periods of extended bull markets, such as the 1990’s, and prevalent during significant market downturns, such as the bursting of the tech bubble and the credit crunch of 2008. Unfortunately, many investors don’t bother identifying their tolerance for risk until it’s too late.
It often takes a major market pullback for many investors to realize their ability to accept risk in their portfolio is not as dominant as they thought. After steep declines in market values, these investors concede they are not comfortable owning such an aggressive portfolio, and they sell investments at a loss in order to make their portfolio more conservative. Of course, selling when investment values are low is not a formula for making money. Consequently, these investors would be better off identifying their appropriate risk tolerance before a market recession, and rebalancing their portfolios while investment values are still high. Then when the inevitable market declines occur, the decrease in an investor’s portfolio will be more in-line with that individual’s ability to accept market losses, making the person less likely to sell at market lows.
The first step in developing a portfolio that matches an individual’s risk tolerance is to identify an appropriate investment allocation between stocks, bonds, and cash. Portfolios consisting of a high percentage of stocks are more aggressive, while portfolios consisting mostly of bonds and cash are more conservative. As investors age, they should constantly reduce the proportion of stocks and increase the proportion of bonds and cash in their portfolio, making their investments less risky.