How to measure your tolerance for risk

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While you can't control what the markets will do next, you can get a handle on how much risk you're comfortable taking with your investments. Thinking through these three basic questions can help.
If you've ever wondered how you'd deal with a challenging market, 2022 has likely put that to the test. In the first half of the year, stocks plunged roughly 20%, shaking many investors' faith in their investment strategy and financial futures.
"Markets can change very quickly and unexpectedly, and we cannot control that," says Niladri Mukherjee, head of CIO Portfolio Strategy, Chief Investment Office, Merrill and Bank of America Private Bank. "What we can control is how we manage risk."
Markets can change very quickly and unexpectedly, and we cannot control that. What we can control is how we manage risk.
— Niladri Mukherjee,
head of CIO Portfolio Strategy, Chief Investment Office,
Merrill and Bank of America Private Bank
The key is understanding your comfort with risk before a crisis hits, so you're less tempted to pull out of the market when volatility strikes and miss out on potential gains when it recovers.
The following questions can help guide you in understanding how much risk you can tolerate — and afford — in any market.

How much risk can you take on and still sleep at night?

This year's development as well as the dramatic drop in stock prices triggered by the coronavirus in early 2020 and the economic shutdown that followed can provide a useful gauge in determining your comfort level in holding riskier assets like stocks versus relatively safer investments, like high-quality bonds and cash. "The goal is to understand how much risk you can truly withstand and still sleep at night," says Mukherjee. That's your "risk tolerance."
You'll also want to determine how much risk you can afford to take with your investments without jeopardizing your goals. Consider things like your income and overall financial resources, along with how much time you have for reaching your goals.
For example, an investor who is in or nearing retirement might balance her portfolio with investments that could provide income and stability of principle, such as bonds, with other investments that could offer the potential for growth, such as equities. On the other hand, an investor who is several decades away from retirement may opt for a larger allocation to equities, with the goal of generating greater growth over time.
The key point being, by understanding how much risk you're comfortable taking and how much risk you can afford taking, you'll be less tempted to abandon the markets when they get volatile — a decision that could hurt your investment returns over time.
As the graphic below illustrates, an investor who pulled out of the stock market during the Great Recession of 2008–2009 and re-invested just one year later would have missed the initial market rebound — significantly reducing their potential returns over the next decade. And someone who exited the stock market and moved their investments into cash would have risked not realizing any returns in the following years.

Abandoning the Markets May Lead to Underperformance

This graph represents the potential monetary risk involved in abandoning markets during volatile periods. Three investor scenarios are considered detailing results over a fourteen year period from 2007 to 2020 and with an initial investment of $100,000. First, an investor that remained in the stock market had a net value of $299,780 by the year 2020. Second, an investor that exited the stock market during the recession of December 2007 to June 2009, and then reinvested in the stock market after a one year period, had a net value of $195,315 by the year 2020. And third, an investor that existed the stock market entirely during the recession and reinvested in cash only had a net value of $57,320 by the year 2020.
Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. © Morningstar. All Rights Reserved.
Another useful strategy, especially if you're new to investing or are unsure about how to get started, is to make a commitment to invest a certain amount on a regular and consistent basis — known as dollar cost averaging. A common way to do this is through a 401(k) plan, if your employer offers one. "It can help reduce the urge to try to time the market," notes Mukherjee, "or make knee-jerk reactions when markets get turbulent."

What's the time frame for your various goals?

It's often helpful to think about the amount of time you have to reach each of your goals, as that will help inform the investment choices you make. Funds to cover unexpected expenses like large home repairs or medical bills or to weather a layoff should be in cash or a highly liquid, low-risk investment such as short-term bonds. For near-term goals that are three-to-five or so years away, such as a home down payment, you might opt for conservative investments that typically aren't as volatile as stocks.
When it comes to long-term goals like retirement, however, being too conservative increases the risk that your portfolio will not grow at a pace that keeps up with inflation. In the decade prior to the pandemic, inflation has been low — generally less than 2% a year. But even a fairly modest 2% annualized inflation rate can dramatically reduce the value of your savings over time.
As the graphic below shows, the purchasing power of $100,000 shrinks to about $82,000 after 10 years, and to about $61,000 after 25 years.

Even modest inflation can shrink the value of your savings. Look at the damage 2% can do over time.

This hypothetical chart shows the negative impact of modest inflation on $100,000 worth of savings. After a 10-year period, inflation reduced the investor's savings to $82,035. After a 25-year period, inflation reduced the investor's savings to $60,953.
Source: Investment Calculator, Bank of Canada. Assumes 2% inflation and 0% interest earned.
Planning around the corrosive effect of inflation is especially important for your retirement security, given that a non-smoker who reaches age 65 in average health has a 50% probability of still being alive into their mid-80s, and living into one's 90s is no longer that uncommon.Footnote 1 So you could consider a larger allocation to equities that offer greater potential for growth for your longer-term goals, Mukherjee suggests.

Are there any special situations that might affect your ability to take risk?

The stability of your income might affect how much risk you can take with your investments. Similarly, if you own your own business or have a lot of equity in your employer's company, you may want to take less risk with your outside investments as a result.
Also take into account significant life changes, such as marriage, divorce, birth of children (and grandchildren), a job loss or new job, even health or caregiving needs. "Your goals and therefore your time horizons for individual goals and risk tolerance is dynamic," says Mukherjee. "If building more near-term security is a priority, you may want to increase your lower-risk investments for a period, which may entail scaling back riskier assets for longer-term goals, such as saving for future college costs."
An investing strategy that is grounded in your life priorities, goals and time horizon and takes your risk tolerance into account is the best way to stay on track and be confident you are making progress.
— Niladri Mukherjee,
head of CIO Portfolio Strategy, Chief Investment Office,
Merrill and Bank of America Private Bank
Working through all those moving pieces can help you build an over-arching allocation of different types of stocks and bonds, periodically rebalanced to ensure that it doesn't stray too far from your predetermined allocation — and level of risk. You might also consider diversifying using real assets like commodities and real estate, as well as alternative investment strategies. "An investing strategy that is grounded in your life priorities, goals and time horizon and takes your risk tolerance into account is the best way to stay on track and be confident you are making progress," says Mukherjee.

Next steps

Footnote 1 Source: Society of Actuaries, June 2020

Opinions are as of the date of this article 07/22/2022 and are subject to change.

Past performance is no guarantee of future results.

This information should not be construed as investment advice and is subject to change. It is provided for informational purposes only and is not intended to be either a specific offer by Bank of America, Merrill or any affiliate to sell or provide, or a specific invitation for a consumer to apply for, any particular retail financial product or service that may be available.

The Chief Investment Office (CIO) provides thought leadership on wealth management, investment strategy and global markets; portfolio management solutions; due diligence; and solutions oversight and data analytics. CIO viewpoints are developed for Bank of America Private Bank, a division of Bank of America, N.A., ("Bank of America") and Merrill Lynch, Pierce, Fenner & Smith Incorporated ("MLPF&S" or "Merrill"), a registered broker-dealer, registered investment adviser and a wholly owned subsidiary of Bank of America Corporation ("BofA Corp.").
Asset allocation, diversification, dollar cost averaging and rebalancing do not ensure a profit or protect against loss in declining markets.
Keep in mind that dollar cost averaging cannot guarantee a profit or prevent a loss in declining markets. Since such an investment plan involves continual investment in securities regardless of fluctuating price levels, you should consider your willingness to continue purchasing during periods of high or low price levels.

Risk management, diversification and due diligence processes seek to mitigate, but cannot eliminate risk, nor do they imply low risk.

Investments have varying degrees of risk. Some of the risks involved with equity securities include the possibility that the value of the stocks may fluctuate in response to events specific to the companies or markets, as well as economic, political or social events in the U.S. or abroad. Bonds are subject to interest rate, inflation and credit risks. Treasury bills are less volatile than longer-term fixed income securities and are guaranteed as to timely payment of principal and interest by the U.S. government. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors.

Alternative investments are speculative and involve a high degree of risk.

Alternative investments are intended for qualified investors only. Alternative Investments such as derivatives, hedge funds, private equity funds, and funds of funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity, and your tolerance for risk.