What does risk tolerance mean in investing?
Risk tolerance is how much your investments can fall in value without causing you a problem. It has three parts: your attitude to risk, meaning how comfortable you are with ups and downs; your capacity for loss, meaning what you can afford to lose; and your time horizon. Each one limits the others.
The mistake people make is to focus on the first one. You might be relaxed about risk, but if you're investing money you'll need for a house deposit in two years, your capacity for loss is low and your time horizon is short. Your real limit is the cautious end of all three.
Attitude to risk
How you feel about seeing your balance drop. Some people shrug at a 20% fall. Others lose sleep over 5%. Neither is wrong, but you need to know which one you are.
Capacity for loss
How much you could lose without it affecting your bills, your plans or your security. This is about your finances, not your feelings.
Time horizon
How long until you need the money. The longer you have, the more time your investments have to recover from a fall.
How long should you invest for?
As a rule of thumb, only put money into shares-based investments if you can leave it for at least five years. Shorter than that, a market fall may not have time to recover before you need the cash. Money needed within a year or two usually belongs in savings, not investments.
Five years isn't a magic number, and markets don't recover on a schedule. Global share markets have fallen by a third or more several times this century, in the early 2000s, in 2008 and 2009, and briefly in early 2020. Some of those falls took years to make back. The longer you can wait, the less likely you are to be forced to sell at a low point. Public money-guidance services in many countries give similar advice about investing for the longer term.
| When you need the money | Where it usually belongs | Why |
|---|---|---|
| Within 1–2 years | Easy-access or fixed-term savings | No time to recover from a fall |
| 2–5 years | Mostly savings, or a cautious portfolio if you accept some risk | A bad year could still leave you short |
| 5–10 years | A cautious to balanced portfolio may suit | Time to ride out most downturns |
| 10 years or more | A balanced to adventurous portfolio may suit | More time for growth to outweigh falls |
General guide only. Your own circumstances may point to a different answer.
How much of a fall could you live with?
The best way to test your attitude to risk is to turn percentages into cash amounts. Picture your actual balance after a bad year, not a percentage on a chart. If seeing that number would make you sell, you've found your limit, and your portfolio should hold fewer shares than that.
Say you invest $20,000. Then share markets fall 30% and bonds fall 5% over the next year. That's a bad but not unheard-of year. The chart and table show what four different mixes might look like afterwards. The figures are illustrative.
How to use the table
Find the row where your gut reaction is 'that hurts, but I'd leave it alone'. That's roughly where your attitude to risk sits. If even the top row would push you to sell, investing in shares may not be right for you yet, and that's a reasonable conclusion.
Remember that the falls in this example are made up to show the maths. Real falls can be smaller or larger, and bonds and shares don't always move in the directions you'd expect.
| Portfolio mix (shares / bonds / cash) | Value after the fall | Loss in cash | Loss in % |
|---|---|---|---|
| 20% / 70% / 10% | $18,100 | $1,900 | 9.5% |
| 60% / 35% / 5% | $16,050 | $3,950 | about 20% |
| 80% / 20% / 0% | $15,000 | $5,000 | 25% |
| 100% / 0% / 0% | $14,000 | $6,000 | 30% |
How much money can you afford to lose?
Your capacity for loss is the amount your investments could fall without changing how you live. It's higher if you have an emergency fund, a steady income, no expensive debt and other savings. It's lower if this money is all you have, or if you're relying on it for a specific goal.
If your capacity for loss is low, take less risk, even if you feel comfortable with it. Your feelings don't pay the bills if things go wrong. Our checklist before you invest covers getting these basics in place.
- Do you have an emergency fund? Three to six months of essential spending in easy-access savings means a surprise bill won't force you to sell investments at a bad time.
- Is your income secure? A stable salary or pension gives you more room than irregular or self-employed income.
- Do you have expensive debt? Credit card or overdraft interest usually costs more than investments are likely to earn.
- Do people depend on you? Children, a partner or relatives you support lower the amount you can afford to lose.
- What else do you have? Pensions, property and other savings all add to your capacity for loss. If this is your only pot, be more cautious.
How does a risk questionnaire work, and can you trust the result?
A risk questionnaire is part of the suitability assessment a firm carries out before it manages money for you, and in many countries it must. It asks about your goals, finances, experience and reactions to losses, then places you on a risk scale. It's a useful starting point, but it only works if your answers are accurate.
The questions can feel personal. They're there because the firm takes responsibility for matching you to the right portfolio, and that includes checking your ability to bear losses, not only your appetite for them.
A few tips. Don't answer the way you think a 'good investor' would. Answer as you'd really behave. If the result surprises you, ask the firm to explain how it got there. And if the firm suggests a higher risk level than you're comfortable with, say so: you're allowed to choose a lower one.
- Answer based on your real finances, not what you hope they'll be next year.
- Think about how you behaved in past market falls, if you've invested before.
- Ask what the worst year for your suggested portfolio might look like in cash terms.
- Keep a copy of the result so you can compare it next time you're reassessed.
When should you change your risk level?
Change your risk level when your circumstances change, not when the markets do. A new job, a baby, a divorce, a large inheritance or getting closer to your goal are good reasons to review it. A frightening headline or a bad month is not, because selling after a fall locks in the loss.
As you get within a few years of needing the money, it usually makes sense to reduce risk gradually rather than all at once. That way a fall right before your deadline does less damage. Many managed services will do this for you if you tell them your target date.
If a market fall has made you realise you took on too much risk, that's useful information. Wait until things have settled if you can, then move to a lower level so it doesn't happen again. Spreading your money widely, covered in our diversification guide, helps too.
How does the managed portfolio match your risk level?
The managed portfolio invests in a mix of funds at the risk level you agree with the provider, which runs a suitability assessment before you invest anything. If you need the money within five years, lack emergency savings or couldn't bear a big fall, it probably isn't for you.
Read the risk disclosure for the specific risks, and how it works for what happens during the call with the provider. The product page for the managed portfolio sets out what it invests in and how you can access your money.