How Much Risk Should I Take When Investing?

If you’re looking to invest, a top priority is determining how much risk to take. Risk might sound scary, especially if you’re not a risk-taker elsewhere in life. But in investing, more risk generally means more return over the long run. So, you’ll need to take at least some risk, but you need to do it in an appropriate dose. Take too much and you might lose a massive amount of money right before you need it. Take too little and your money might not grow to the sum that you need.

You can determine your risk level using the three steps below.

Step 1: Establish your goals. First, determine, quantify, and prioritize your investment goals. This is necessary because different goals--like an emergency fund, retirement, or a down payment on a house or a car--have different time frames that require different risk levels.

Goal setting is more difficult than it may seem. It requires answering big questions like “When will I retire and how much yearly income will I need?” and “Should I buy a home, and if so, when and for how much?” You then have to prioritize these goals and allocate limited dollars to saving for them. These questions are hard to answer perfectly, so make your best estimate for each goal. (In the worst case, you go back and refine them later.)

Step 2: Assess your risk capacity to determine general risk allocation. Risk capacity helps you understand the optimal amount of risk you could take in order to maximize the chance that you reach your goal, depending on how far you are from that goal. If you're further away, you can handle the risk that your portfolio loses money for short periods. These bumps smooth out over time, and investors tend to earn a higher return for bearing more risk. In other words, high-risk-capacity investors (or investors with a long investing runway) want more risk to maximize their long-term return and their final sum. (Note that we can define risk in many ways, but we commonly use volatility, or how much an investment's return varies around its average.)

What counts as a long time in investing? Generally, it's 10 or more years away, which makes retirement a prime example. Investors in their 20s and 30s are far away from retirement, so they can load up on risky investments like equities, which offer higher long-term returns but are prone to price volatility along the way. Morningstar's Lifetime Allocation Indexes can give you a helpful starting point for your allocation. For instance, if you're 40 years away from retirement, you could target about 90% in stocks and 10% in bonds and cash, but these figures should shift as the portfolio becomes more conservative over time. Plus, you can fine-tune your exposure depending on how aggressive or conservative you want your portfolio while still staying within the recommended risk range (more on that in Step 3).

Meanwhile, short- and intermediate-term goals require less risk because your portfolio has less time to recover if the markets drop. So, you would own more bonds and cash when saving for a short-term goal, but the amounts vary greatly depending on your specific time horizon. If you are saving for a goal that is two or fewer years away, you should generally hold all cash. On the other hand, goals around 10 years away might include a small helping of stocks. If you're unsure how to translate your risk capacity into an allocation, Christine Benz provides some general guidelines and recommended portfolios based on time horizon. (You can also examine your portfolio's allocation through Morningstar's x-ray tool.)

Benz’s allocations aren’t definitive rules because everyone’s situation differs and no one knows how markets will perform. Therefore, you should pick an allocation that gives you a high likelihood of reaching your goal but also makes you feel comfortable.

Step 3: Tweak risk capacity (if relevant) based on risk tolerance. Your risk capacity should largely dictate your risk level, but you might also examine your risk tolerance, or how market swings make you feel. You might know short-term losses won't ruin long-term returns, but how uncomfortable does a 40% portfolio decline make you feel? It's hard to know until the situation arises, but if you think it would make you uncomfortable, then you might have a lower risk tolerance.

Investors who don’t consider their risk tolerance might harm themselves by adjusting a portfolio’s risk at the worst time. If a portfolio loses 40% of its value, a risk-averse investor might get so anxious that she swaps out stock holdings for bonds and cash. However, these adjustments can minimize how much of the eventual rebound her portfolio captures, decreasing the likelihood that the investor will reach her goal. But if the portfolio was less risky from the beginning and therefore declined by less--say 25%--an investor with a low risk tolerance might feel comfortable enough not to make any changes.

Note, though, that risk-tolerance adjustments need to be small. You’re investing for a specific goal, so if your adjustments prevent you from earning a return needed to reach your goal, you’ve defeated goal-based investing’s purpose.

Morningstar's Lifetime Allocation Indexes can offer guidance when determining if an allocation tweak is reasonable. The indexes contain aggressive, moderate, and conservative portfolios, and these portfolios contain asset allocations that differ slightly in the early years, and more dramatically in the later years. At 40 years until retirement, the moderate portfolio contains 90% in equity funds, while the aggressive and conservative portfolios are within striking distance, at 94% and 83%, respectively. At 25 years until retirement, the moderate portfolio's equity stake is around 84%, while the aggressive and conservative portfolios are at 94% and 65%, respectively.

Instead of adjusting your stock or bond allocation, you could also fine-tune the stock and bond investments that you own. Investors with a high risk tolerance could consider a heavy helping of small-cap stocks, for instance.