Risk tolerance is your capacity and willingness to accept short-term losses in your investment portfolio in exchange for potentially higher long-term returns. Understanding your risk tolerance is essential to choosing an asset allocation you can stick with through market downturns.
The Two Components of Risk Tolerance
1. Risk capacity (objective) — your financial ability to withstand losses:
- How stable is your income?
- Do you have an emergency fund outside your investments?
- Do you have other assets or income (super, property, partner’s income)?
- When do you need this money? (longer horizon = higher capacity)
- Do you have dependants who rely on your financial stability?
2. Risk willingness (subjective) — your emotional comfort with portfolio volatility:
- How would you feel if your portfolio fell 30% in a year?
- Would you sell or stay invested?
- Have you experienced significant market falls before?
- Do market news cycles cause you significant anxiety?
Your investment risk tolerance is the lower of your capacity and your willingness. A high-income investor who panics at the first sign of market losses has low risk tolerance despite high risk capacity.
Why Risk Tolerance Matters More Than Returns
Many investors choose an aggressive growth allocation because they focus on historical long-run returns — then sell in panic during a bear market, locking in losses at the worst moment.
The worst investment outcome is not holding a slightly sub-optimal asset allocation — it is holding a perfectly optimal portfolio in good markets, then panic-selling when it falls 30%.
A slightly more conservative portfolio that you can hold through a 30% drawdown will outperform an aggressive portfolio that you abandon at the bottom.
Assessing Your Risk Tolerance
The simple test: How would you react to a 30% loss?
| Reaction | Implied risk tolerance |
|---|---|
| I would immediately sell to stop further losses | Very low — conservative portfolio |
| I would feel worried but not sell | Low–medium — moderately conservative |
| I would be uncomfortable but stay invested | Medium — balanced portfolio |
| I would be concerned but might buy more | Medium–high — growth portfolio |
| I would definitely buy more — it’s a great opportunity | High — high growth portfolio |
The time horizon test
| Years to goal | Maximum comfortable growth % |
|---|---|
| <2 years | 10–30% |
| 2–5 years | 30–50% |
| 5–10 years | 50–70% |
| 10–20 years | 70–85% |
| 20+ years | 85–100% |
Risk Tolerance vs Risk Capacity Conflict
If your risk capacity is high (30-year horizon, stable income, large emergency fund) but your risk willingness is low (you’d sell in a crash), what do you do?
Options:
- Start conservative and gradually increase allocation over time as you gain comfort
- Automate investing (direct debit) so market falls don’t trigger an emotional decision to stop
- Educate yourself on historical market cycles — understanding that downturns are temporary is the most effective counter to emotional selling
- Accept a slightly lower expected return in exchange for better sleep and sticking to the plan
The plan you can stick to beats the plan you abandon.
Risk Tolerance Changes Over Time
Risk tolerance typically evolves:
- Young investors: High capacity, often high willingness (haven’t experienced a crash)
- Mid-career: High capacity, often reduced willingness (more assets at risk, more life commitments)
- Pre-retirement: Reduced capacity (shorter time horizon), varied willingness
- In retirement: Lowest capacity (income dependence on portfolio), varied
Review your risk tolerance every 3–5 years or after major life changes (new job, marriage, children, approaching retirement).
Super Fund Risk Profiles
Most Australian super funds classify investment options by risk level. The standard labels (set by ASIC):
- Very Low (defensive) → Very High (aggressive)
- Each option has a disclosed “Standard Risk Measure” — the expected number of negative return years in 20
A “High” risk option might have 4–6 expected negative years in 20 — that’s one bad year every 3–5 years. Being prepared for this makes it easier to stay invested.
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Frequently Asked Questions
What is a good risk tolerance for investing in Australia? There is no universally “good” risk tolerance — it depends on your financial situation, time horizon, and personal comfort with loss. As a general guide, investors with 10+ years to their goal and stable income can afford to take higher risk (80–90% growth assets); those within 5 years of needing money should reduce risk (40–60% growth).
How do I know my risk tolerance? The most reliable indicator is how you have behaved in previous market downturns. If you’ve never experienced a significant market fall, imagine how you’d react to seeing your $100,000 portfolio fall to $65,000 in 12 months — would you sell, freeze, or buy more? Most robo-advisers and super funds offer risk questionnaires as a starting framework.
Can you change your risk tolerance? Your risk willingness can change through education (understanding that market falls are normal and recoveries happen), experience (surviving a bear market without selling), and life circumstances (fewer financial commitments, higher income). Risk capacity changes with time horizon — as you approach retirement, your capacity naturally decreases regardless of willingness.
This article provides general financial information only. For advice tailored to your situation, speak with a licensed financial adviser through the ASIC financial advisers register or MoneySmart.