Risk Tolerance: A Fundamental Factor in Financial Planning

Someone may feel comfortable skiing a black diamond but draw the line at skydiving. Another person may be willing to start a business but unwilling to invest in the stock market. Every individual makes decisions every day that involve a certain level of risk, and that risk is going to look different for each person. In financial planning, this instinct has a name: risk tolerance.

Risk tolerance is an important tool used by financial planners to assess and guide a Client’s approach to wealth management, though the concept extends beyond just money. In totality, risk tolerance is the level of risk you are willing and able to assume. When broken down, risk tolerance includes risk appetite (how much risk you are willing to take on) and risk capacity (how much risk you are able to take on). These elements are further shaped by your risk perception — your attitude toward and views on risk. Factors such as your time horizon, financial goals, age, portfolio size, and investor knowledge all contribute to whether you have an aggressive, moderate, or conservative risk tolerance.

Understanding where you fall on that spectrum is where the work of financial planning truly begins. In this piece, we explore how we assess risk tolerance, why it matters, and how it shapes the advice we give.

How is risk tolerance assessed?

We glean your risk tolerance through both informal and formal methods. Most assessments start with a risk tolerance questionnaire. Though the length of these questionnaires varies (ours is 25 questions long), the goal is the same: to assess your risk capacity, risk perception, and risk appetite. Some questions may be qualitative, while others may be more quantitative in nature. The questions are typically multiple-choice, and their themes can vary widely. The following are some examples of topics that these questions might cover:

• Perception of the word “risk”
• Opinions on job security and compensation structures
• Lifestyle and financial decision-making
• Types of investments
• Portfolio allocations

Below are some sample questions from our questionnaire:

Once you have completed the questionnaire, your risk score is plotted on a normal distribution which illustrates where your risk tolerance falls in relation to the general population.

Our risk tolerance software, provided by the investment research firm Morningstar, takes these results a step further and provides context about your risk profile and how you may respond in a given situation. You are also provided with a summary of your response to each question and how your responses informed their risk group. We keep track of your risk tolerance questionnaire results and reference this data when making investment recommendations or engaging in sensitive discussions regarding risk.

After digesting the results of your questionnaire, our understanding of your risk tolerance is deepened by the conversations that follow. Many conversations offer clues about your risk perception and appetite by revealing formative life experiences, your familiarity with money, past financial mistakes and successes, and how you view the role of money in your life. All of these shape the conversations we have with you about risk.

Notably, risk tolerance is dynamic. The level of risk you are willing and able to take on as a single 20-year-old is far different than as a married, 50-year-old parent of three. A younger person with fewer responsibilities may be more willing, but less able, to take on risk, whereas someone in a later season of life with more familial considerations may be more able, but less willing, to take on risk. Moreover, your views — shaped by experiences, belief systems, and knowledge — will likely change over a lifetime. It is vital that we continuously assess your risk tolerance and adjust our advice accordingly. Risk tolerance, in other words, is not a box checked once at the start of a relationship, but a living part of the financial planning process.

Why does risk tolerance matter?

Our goal is to provide you with the best available financial guidance, and your risk tolerance is central to that. Understanding your risk tolerance allows us to present a plan that leaves you feeling comfortable and confident, and it promotes more effective communication between us.

The most well-known application of risk tolerance is the recommendation of an appropriate investment allocation. In practice, a higher risk tolerance means you may feel more comfortable experiencing short-term losses in exchange for long-term gains. As a result, Clients with higher risk tolerances will often invest in more aggressive portfolios with more volatile investments, such as a portfolio invested 100% in stocks. On the other hand, Clients with lower risk tolerances will typically invest in more conservative portfolios, such as one invested 60% in stocks and 40% in bonds. That said, the traditional financial planning response – “it depends” – applies here. If you have a high appetite for risk, you may still be recommended a lower-risk portfolio because you cannot afford to risk losing money that might be needed for short-term spending. This is another reason why understanding the totality of your financial picture matters.

Consider two Clients in a period of market volatility – say, a global pandemic a la 2020. One, with a lower risk tolerance, feels uneasy and wants to step back from investing altogether. Another, with a higher risk tolerance, sees the same moment as an opportunity to buy low. For us to properly advise the more risk-averse Client, we need to take things slow, ask questions to understand what is driving the unease, and make sure you feel heard before recommending a path forward. The goal is to help you ease in gradually, taking small steps toward a goal that may once have felt overwhelming.

Beyond the realm of investing, risk tolerance can come into play in various scenarios during our financial planning relationship. Consider building a new home, taking on a career change, or planning a major life transition. In each of these situations, your risk tolerance shapes how you weigh potential outcomes, and how much uncertainty you are willing to accept in pursuit of a goal. An astute planner will help you see the full range of risks involved in any given decision, drawing on your own life experiences to paint a more complete picture and helping you understand whether the level of risk you are prepared to take on aligns with what your plan can actually support.

What’s your next step?

If you are curious about how your risk tolerance influences your thought processes or informs our advice, please reach out to us. We would be happy to explore the topic together to gain a deeper understanding of your risk tolerance and the role that it plays in your financial life.