Weighing risk & reward: The importance of understanding your risk tolerance

When it comes to risk tolerance, Thrivent client Jules Andres says she’s moderately aggressive, willing to endure losses in favor of potential greater returns in the long term.

In her 50s, Andres, from Redondo Beach, California, admits that she had a higher risk tolerance when she was younger, especially with the benefits of an employer-sponsored 401(k). But now that she’s the owner and CEO of her own corporate communications consulting business, she’s responsible for managing her own retirement.

“I’ve remained a little bit aggressive, and I don't get freaked out by the market changes too much,” Andres says. “I understand when fluctuations are coming so I can manage my expectations.”

Risk and reward often go hand in hand, especially when it comes to investing in the stock market. The thought of growing your wealth can be exciting, but more risk could result in a higher chance of loss. One of the most foundational elements of investing is understanding your tolerance of risk and what helps shape it.

Sarah Auernhammer, Thrivent wealth advisor in Hermosa Beach, California, is Andres’ financial advisor. When Auernhammer works with clients, she gets an understanding of their risk temperament using Thrivent’s AssetMatch Assessment. The tool helps determine where people fall on a scale of risk tolerance, categorizing them as conservative, moderately conservative, moderate, moderately aggressive or aggressive.

Risk tolerance can be impactful when considering three important investment factors.

You likely have goals for your money. For example, you may want to purchase a house, retire early or save for the next generation. How you want to use your money can factor into how much risk you can withstand.

“Setting goals establishes some guardrails over the course of your financial life, understanding the why behind your investing dollars, what you hope to accomplish, and by when,” says Dave Kloster, president of Thrivent Investment Management Inc. “Defining that plan is critical.”

For example, Andres had a pre-retirement goal to purchase a custom Overland Sprinter van built out with all the bells and whistles so she can travel and work from the road. She was able to accomplish this goal and pay for it in full.

“My next goal is to ‘mostly’ retire at 59, explore the U.S. in my adventure van, do some writing for pleasure, and not worry about money,” says Andres. “It’s also important to me to be able to give generously without stress, such as tithing, supporting causes and giving in a crisis.”

Generally, a more conservative risk tolerance can be associated with a lower rate of return on an investment. Conversely, a more aggressive approach to investing may result in a higher rate of return. Understanding the purpose of your investment returns will help you clarify your risk tolerance and choose solutions that will help you meet your long-term goals, even with inflation’s impact.

“Anything beyond an emergency fund in today's world, we often have to make work harder for us in an effort to outpace inflation,” says Auernhammer. “Inflation recently has been as high as 9.1%.* If you’re keeping a significant portion of your investment dollars in your savings or checking account, you may not be getting a return that keeps up with or outpaces inflation.”

Your timeline and need for liquidity also can impact your risk tolerance. Generally speaking, the longer you have until you need the money, the more risk you're able to take as you will have time to recover if the markets fall.

Goals can impact your investing timeline. For example, if your goal is to leave a legacy for future generations, being very conservative may not make sense. Or if you need liquid funds during retirement, then during your retirement years you may not want to be aggressively invested in equities.

“You may not be able to afford to stomach double-digit losses in a given year, which is possible in the markets,” says Kloster.

One misconception about managing risk tolerance is that it’s only tied to your age, says Ray Weiss, Thrivent financial advisor in Brenham, Texas. “People think when they’re in their 60s, they need to put everything into conservative investments,” he says. “That is not totally correct.”

At 65 you may need your money to potentially grow for another 30 or 40 years, due to increased life expectancy. That’s why understanding your risk tolerance and adapting your investments to potentially seek growth while still leaving you feeling comfortable is important, Weiss says.

“We have clients nearing retirement that will tell me they need to change their risk tolerance to reduce risk, but yet their tolerance for risk hasn’t changed and they may need those assets for a long time,” Weiss says. “This is where we educate on understanding what their risk tolerance is and how they can adapt their strategy to meet their needs. At the end of the day, we want to identify what will keep them up at night so they can make the right choices.”

How much risk you can handle also can depend on your temperament. “Risk tolerance is a very personal thing,” says Kloster. “Your goals combined with your attitudes toward money will form and shape your risk tolerance over time.”

Kloster says your risk tolerance and your risk capacity may or may not be in alignment. For example, someone just joining the workforce in their late teens or early 20s and beginning to save for retirement through an IRA or a workplace 401(k) has a long time until retirement.

“In theory, someone like that should have a larger risk capacity, the ability to take on more risk, because that time horizon is so long,” he says. “But they also may be somewhat of a panicky investor and may not be comfortable taking on that greater risk.”

Auernhammer has clients who are comfortable with the stock market and understand that volatility could occur. “They understand that's just the nature of being invested in the stock and the bond market,” she says. “They would fall into more of an aggressive risk tolerance category. Someone who’s conservative may not be able to sleep at night if they see their account balance go up or down in today's environment.”

Risk tolerance also can be connected to financial literacy, says Auernhammer. “Some clients who aren’t experienced in investing may need to be educated to understand they can handle the short-term volatility of the market if they have a long time horizon,” she says.

Your risk temperament often changes over time as your life changes. “It can be because you're becoming more comfortable in your investment strategy,” says Auernhammer. “It may change because you may need more money in the short term because you're going to be retiring soon. Your risk temperament is based on what's going on in the world and what stage you are in using those monies.”

There are other factors that can impact your risk tolerance as well, Weiss says. These include:

• Income: The dollars you can comfortably invest for a short- or long-term goal without impacting your current lifestyle. If you have more disposable income, for example, you may feel more comfortable with risk.

• Market conditions: While it’s important to not let emotions guide your decisions, Weiss says, market conditions may play a role in how conservative or aggressive you want to be in your investing approach. Reflect on your feelings during a market condition, and also assess the facts. Share those feelings with your financial advisor.

• Past experiences: Since money is often an emotional topic, it’s essential to understand what past experiences could be impacting how you tolerate risk.

All the financial decisions we make come with some level of risk. One of the best ways to become more comfortable with risk and your risk tolerance is to work with a qualified financial advisor who can help you tailor your investments to align with your goals, timeline and attitudes toward money.

For example, Auernhammer created a financial strategy for Andres that includes a Self-Employed Pension (SEP), a managed account, Roth IRA and a traditional IRA, each invested in specific mutual funds that help balance her risk and match her risk tolerance.

“As a communications consultant, people reach out to me for help with their communications needs,” says Andres. “When I needed help planning for my financial strategy, it’s natural that I would reach out to someone with financial expertise. I don't understand the intricacies of the market. Having someone like Sarah has given me more confidence that I’m heading in the right direction.”

• Conservative investors avoid financial risk whenever possible and focus on not losing money. They are willing to trade lower returns and slower growth for more stability in their overall investments. If money may be needed in the near term, investing conservatively may be a wise option.

• Moderately conservative investors want to invest, but without taking large risks. Their main priority is to not lose their investment and they are OK with low and slow returns. They may need to withdraw money soon, so an investment profile that leans to the conservative side would be an option to consider.

• Moderate investors are in it for the medium to long term. The usual up and down fluctuations of the market are fine, as long as it nets a higher return. If the volatility lasts too long, moderate investors may start to consider withdrawing a portion or all of their investments.

• Moderately aggressive investors want to be rewarded for the risks they take. They are not the most aggressive investors and probably don’t need access to their money for a while. Moderately aggressive investors have the mindset that if they hang in there, their investments will pay off in the end, but there may be some ups and downs along the way.

• Aggressive investors have one goal: Maximize returns. Anything that is underperforming isn't a concern because they're optimistic and in it for the long term. Taking bigger risks is their game as time is on their side since they don't expect to withdraw their investments for a quite a while.

Thrivent financial advisors can help you understand your risk tolerance and how it can help you make smarter investment decisions.

Want to learn more about your investing style now? Take this quiz to see where your risk tolerance stands.