Before you put even one dollar into the market, you must answer a hard question: How much money can you lose without getting very scared or making a bad choice?
This is called risk tolerance. If you understand your risk, you can make a good plan for your money and not worry too much.
What Does Risk Tolerance Mean?
Risk tolerance is how much you can handle your money going down so that it might grow later. It is not only about numbers but also about how you feel about it.
Two things make up your risk:
- Your financial capacity: Can your bank account handle a loss? If you have an emergency fund (extra money for 6 months) and no bad debt, you can take more risk. If you have no extra money, you cannot take many risks.
- Your emotional capacity: How do you act when your money drops 20%? If you say, “I must sell everything right now because I am scared,” then your risk tolerance is very low.
You must think about both. If you ignore one, you will make a mistake with your money.
Why Risk Tolerance Is So Important
A big survey in 2023 found that only 61% of Americans own stocks or have retirement accounts. Many people do not invest because they are very afraid of losing their money.
Being afraid is normal. But if you do not understand your risk, two bad things can happen:
- Too much risk: You take a big chance, the market goes down, you get scared, and you sell everything. This makes you lose money.
- Too little risk: You keep all your money in a basic bank account. Then, inflation makes things more expensive, and your money can buy less every year.
Both of these are big mistakes that cost you a lot of money.
The Three Kinds of Investors
Most people who invest fit into one of these three groups:
| Group | What they want | What is in their account |
|---|---|---|
| Conservative | To keep their money very safe. | Mostly bonds, cash, and safe things. |
| Moderate | A mix of safety and growing their money. | A balance of stocks and bonds. |
| Aggressive | To grow their money as much as possible. | Mostly stocks, which can go up and down a lot. |
You do not have to stay in the same group for your whole life. Your group changes when your life changes. For example, a 28-year-old person saving for old age can take more risk than a 58-year-old person who needs to spend their money soon.
How Much Time Do You Have?
The amount of time you have to invest changes everything. If you have many years, you can take more risks. This is because the market goes up and down in the short term, but usually goes up over many years.
The S&P 500 (a group of big U.S. companies) has grown by about 10% every year on average for the last 50 years. But some years were very bad.
There is a simple “rule” you can use. Take 110 and minus your age. The answer is what percentage you should have in stocks.
Example: If you are 30 years old (110 – 30 = 80), you should have 80% stocks and 20% bonds. This is not a perfect rule for everyone, but it is a good place to start.
Risk tolerance is not something you just check one time and forget. It is something you must think about again and again as your life changes. If you get it wrong, your money will suffer. If you get it right, you can stay calm and keep your money in the market even when the prices look scary.
