How do I determine my risk tolerance?

Understanding your risk tolerance is an important early step in investment planning. But consider this: It’s not how much risk you’re willing to take. It’s how much risk you can afford to take.

What do you mean by “risk tolerance”?

Risk tolerance is the amount of risk you’re willing to take to achieve your financial goals, whether that’s producing income, creating long-term growth, or both.

Investors typically fall into one of three risk categories: conservative, moderate, or aggressive.

Conservative

These investors generally assume a lower amount of risk, but may still experience losses or have lower potential returns.

Moderate

These investors are willing to accept a modest level of risk that may result in increased losses in exchange for the potential to receive modest returns.

Aggressive

These investors seek a higher level of returns and are willing to accept a higher level of risk that may result in greater losses.

How will my risk tolerance impact my investment choices?

While risk tolerance is essential, your need for income and/or growth and your time horizon also are principal considerations.

Your investment objectives will define what you want your investments to do for you, and the resulting risk/return structure.

Cogs representing investment objectives

Income

This is expected to provide lower relative returns and experience lower risk.

Income plus growth

Growth and Income portfolios are expected to provide higher potential returns and experience greater levels of volatility.

Growth

A Growth portfolio has the highest relative levels of return potential and risk.

What’s the connection between risk and return?

Generally speaking, investments with greater risks can produce greater losses, but can also lead to higher levels of returns. The portfolios below demonstrate the range of potential risk vs. potential return; as you can see, even within the three main objectives, there is a range of lower and greater risk, depending on the investor’s risk tolerance.

This illustration shows that, typically, the greater potential for return is accompanied by a greater potential for risk.

This illustration shows that, typically, the greater potential for return is accompanied by a greater potential for risk.

Source: Wells Fargo Investment Institute. This chart is for illustrative purposes only. Chart is conceptual and does not reflect any actual returns or represent any specific asset allocations.

What factors can impact your portfolio risk?

These four factors in particular can have an outsized impact on your portfolio.

  • Time Horizon

    How much time do you have to work toward your investment objectives? Investors with shorter time horizons will likely want to reduce risk to preserve savings, while investors with longer time horizons may consider taking on more risk for more potential growth.

  • Diversification

    Portfolios that are diversified across fixed income, equities, real assets, and alternative investments generally have seen less historical volatility.

  • Liquidity

    While some types of investments can be converted to cash quickly, many alternative investments, however, are only available to qualified investors and may have lock-up periods of three months to 10 years or more but may offer greater potential returns or lower potential volatility in exchange for the liquidity risk.

  • Taxes

    Any special or unique tax needs you have may determine how your portfolio should be structured. For example, if a large portion of your portfolio is invested in just one company’s stock, the rest of your portfolio may be invested to help mitigate the concentration risk of that holding.

What are my key takeaways?

key takeaways icon

1

When planning for long-term financial success, first determine your investment goals.

2

Next, you should determine the level of risk you are willing to take in order to achieve those goals.

3

Whether your risk tolerance is conservative, moderate, or aggressive, we believe that diversification can help you to manage risk.

All investments are subject to market risk which means their value may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors due to numerous factors some of which may be unpredictable. Be sure investors understand and are able to bear the associated market, liquidity, credit, yield fluctuation and other risks involved in an investment in a particular strategy.

Diversification cannot eliminate the risk of fluctuating prices and uncertain returns.

Wells Fargo Investment Institute is not a legal or tax advisor.

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