What does risk tolerance mean?

Let’s say, hypothetically, that you can drink your friends under the table. They might remark, “Dang, you have a high tolerance!” Your tolerance for something simply means how much of it you can endure without ill effect.

Similarly, your risk tolerance refers to how much fluctuation (up and down) you can endure in the value of your investments as you strive to grow them over time. Building your ideal investment portfolio begins with understanding your tolerance for risk.

Investments can suffer short-term losses but long-term gains

Many investments are uncertain. It’s the nature of the game. During an average year, the stock market might at times decline in value by 13% or more. However, in most years, the stock market still ends with positive gains, despite those drops! That’s why investing is a long-term endeavor.

Show me the numbers

This chart shows the biggest market drop (or the “maximum drawdown”) for each year from 1980 to 2018. Max drawdown refers the biggest loss from a high to a low before a new high is attained. Reassuringly, the chart also shows that most years end with a positive annual return.

Source: Clearnomics

Determining your own risk tolerance

When we look at market highs and lows historically, the overall market has always continued to rise over the long haul. How many lows you can withstand in the short term depends on factors like how soon you need to access to your investment (can you leave the money alone to grow for ten years or are you planning to retire and need it in two years?), your other savings and income, and your overall comfort with risk.