Key takeaways
- Investor.gov defines risk tolerance as your ability and willingness to lose some or all of an investment in exchange for greater potential returns.
- Ability is financial: when you need the money and what else you have. Willingness is emotional: whether you can sleep at night holding the investment.
- Money needed within about five years generally does not belong in risky investments; money for goals decades away may be able to take more risk.
- Losses need larger gains to recover: a 20% fall needs a 25% rise, and a 50% fall needs a 100% rise.
- Online risk questionnaires can help, but Investor.gov warns their results may be biased toward the sponsor's products.
Every investment answers two questions at once: how much might this earn, and how much might it lose along the way? Risk tolerance is about the second. Investor.gov defines it as an investor's ability and willingness to lose some or all of an investment in exchange for greater potential returns. That definition contains two separate tests, and they do not always point the same way.
Ability and willingness
| Ability to take risk | Willingness to take risk | |
|---|---|---|
| What it measures | Whether your finances can absorb a loss | Whether you can live with one |
| Shaped by | When you need the money, income, savings, debts | Temperament and experience |
| Investor.gov's framing | When you will need the money, and your goals | Whether you will be able to sleep at night holding a risky investment |
The two can conflict. A 25-year-old saving for retirement has decades of ability but may panic at the first fall. A cautious saver close to buying a home may be willing to gamble but has no ability to recover if the deposit shrinks.
Time horizon changes the answer
Investor.gov's asset allocation guidance defines the time horizon as the number of months, years or decades you plan to invest to reach a goal, and notes that investors with longer horizons may be more comfortable with riskier or more volatile investments.
Its "gauge your risk tolerance" page gives two contrasting cases:
- 35 years to retirement. You may want to consider riskier investments, because sticking only to savings products or low-risk investments may make your money grow too slowly, and inflation and taxes may erode its purchasing power. Investor.gov calls putting long-term money in low-interest investments a frequent mistake.
- A goal five years away or less. You do not want risky investments, because when it is time to sell, you may have to take a loss.
Splitting money by goal helps: an emergency fund, a house deposit and a retirement account can each have a different risk level.
A drawdown test in dollars
Percentages feel abstract until they are dollars. Investor.gov notes that large-company stocks as a group have lost money on average about one out of every three years, and it generally defines a bear market as a fall of 20% or more in a broad index over at least two months. Imagine a $10,000 portfolio:
| Fall | Portfolio becomes | Gain needed to get back to $10,000 |
|---|---|---|
| 10% | $9,000 | 11.1% |
| 20% | $8,000 | 25.0% |
| 33% | $6,700 | 49.3% |
| 50% | $5,000 | 100.0% |
Two lessons. First, ask honestly what you would do at each row: hold, add money or sell. Selling at the bottom turns a temporary fall into a permanent loss. Second, losses are asymmetric: the deeper the fall, the larger the percentage gain needed to recover, which is why limiting large losses matters. Volatility explained covers how the size of typical swings is measured.
Questions to ask before any investment
Drawing on Investor.gov's guidance:
- When will I need this money? Investor.gov's guidance is that money for a goal five years or less away does not belong in risky investments.
- What happens if I lose some or all of it? That is the definition of risk tolerance in practice.
- Do I understand it? If you cannot explain how it makes or loses money, you cannot judge how much it might lose.
- How do the risks compare with the rewards? Higher potential returns come with greater risk, and pitches of high returns with little or no risk are a hallmark of fraud; see investment fraud red flags.
- Is it spread out? Diversification and a mix of assets such as stocks and bonds reduce the damage any one holding can do.
Questionnaires and professional advice
Investor.gov notes that some investment websites offer free online questionnaires to help assess risk tolerance, but warns that results may be biased towards the products or services of whoever sponsors the website.
When a broker makes a recommendation, the firm is expected to know your situation. FINRA's suitability rule, which applies where the SEC's Regulation Best Interest does not, lists what a customer's investment profile includes: age, other investments, financial situation and needs, tax status, investment objectives, investment experience, time horizon, liquidity needs and risk tolerance. Working through the same list yourself is a sound way to prepare.
A simulator can show how a position's value swings, though it cannot reproduce the feeling of losing real money. Learn to Trade Stocks Beginner, one of our education apps, uses a virtual balance for exactly that kind of practice. The investing basics hub lists the related guides.
Good to know
Frequently asked questions
What is risk tolerance?
How does time horizon affect risk?
Can risk tolerance be too low?
Are online risk tolerance quizzes reliable?
Sources
- Risk Tolerance (glossary) (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
- Gauge Your Risk Tolerance (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
- Asset Allocation and Diversification (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
- Five Questions to Ask Before You Invest (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
- Rule 2111. Suitability (opens in a new tab)FINRA — accessed
- Stocks – FAQs (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
- Bear Market (glossary) (opens in a new tab)Investor.gov, U.S. Securities and Exchange Commission — accessed
About the author
Reign Creative LLC — The independent app studio that builds the apps covered on this site and publishes every article here. On Google Play it publishes as Reign Collective Apps.
We use AI tools to help research, draft and edit our articles. Each article lists the sources its factual claims rely on, and details about our apps come from their live Google Play listings. No article on this site has been reviewed by an independent expert unless the reviewer is named on it.
No person at Reign Creative LLC has read this article in full. It was published after automated checks and an AI editorial review, which are described in our editorial policy and are not the same as a person reading every sentence.
Spotted an error? Tell us — how corrections are handled is set out in our editorial policy.