The Factors that Drive Risk Tolerance
I’m Andy Temte and welcome to the Saturday Morning Muse! Start to your weekend with musings that are designed to support your journey of personal and professional continuous improvement, and to improve financial literacy around the world. Today is April 19, 2025.
So far this month, we’ve defined what risk is, introduced the concept of risk tolerance/aversion, and illustrated the link between self-confidence, self-esteem, and risk tolerance. Today, we’re going to discuss other factors that influence your tolerance for taking calculated, informed risks. As a reminder, we’re not talking about risk seeking—or purposefully seeking out risk for the sake of experiencing the thrill of risk. That’s an entirely different subject.
Before we dive into the list of factors that affect risk tolerance, I want to be clear that we’ll be talking about both your ability and willingness to take on risk. Your willingness to take risk is related to your feelings, expectations, and behaviors. Your ability to take risk is more mechanical and is related to things like income levels and your net worth. I’ll be using these words fairly carefully as we proceed.
Another important concept to introduce is ceteris paribus — latin for “all else the same” or “holding all else constant.” This phrase is going to come in handy in our financial literacy lessons because the global macroeconomy, investing, and personal consumption are wildly complex processes with many points of interconnectivity. Rarely does one variable rise causing another to fall in a one-to-one relationship with no other impacts from other variables. Therefore, to keep things simple as we illustrate various financial and economic concepts, we’ll deploy ceteris paribus as a teaching tool. The important point to remember is that nothing is as simple as it seems—and as your level of financial literacy grows, so too will your ability to think critically and consider the impact of multiple variables at once.
So back to the main storyline. Other than my personal self-confidence and self-esteem, what are some of the additional factors that impact our relationship with risk?
Time Horizon: Time horizon can also be thought of as the expected holding period of an asset or investment, and the length of time you expect to hold an asset impacts the level of risk you’re willing and able to take. Holding everything else constant, the longer the expected holding period, the more risk an investor should be willing and able to take. Why? Because a longer holding period or time horizon will allow you to “ride out” or hold onto the asset during short-term downturns in the market. Note that I’m using the phrase “all else constant,” or “all else the same” when talking about the relationship between time horizon and risk tolerance. For example, if during the holding period the long-term expectations for the rate of return (or gain) for the asset changes, then our willingness to hold this asset might change. In this case, all else wasn’t the same—return expectations changed—leading us to reconsider our willingness to continue to hold the asset.
Age: Your age and time horizon are interrelated factors that affect risk tolerance, but they are not the same. Again, holding all else constant, the younger you are, the more risk you’re willing and able to take. However, a young person can have a short investment time horizon to support a major purchase like a house or a business, and may be willing or able to take less risk with their money to avoid a catastrophic short-term loss that would disrupt their plans. Keeping things simple for now, when you’re young and have a long investment time horizon, your investment portfolio will tilt toward more risky assets like stocks. As you age, time horizon shrinks and your willingness and ability to accept short-term losses decreases significantly. Said differently, you’ll need to access your money sooner rather than later, so stability is preferred over the prospect of higher returns.
Income/Earning Capacity: As we discussed time horizon and age in the two points above, note that I was using willingness and ability. In these next two points, we’ll be focusing more on your ability to take risk. Your ability to recover from short-term losses with future gains impacts risk tolerance. All else the same, if your earning capacity is higher—your annual income is higher—you’ll be willing to take more risk because you can earn more money in the future to recover from short-term losses. For example, suppose we have two individuals who are identical in every respect other than one person earns $100,000 per year and the other individual earns $1 million per year—these two individuals are thinking about investing in a risky stock. Again, all else the same, the lower earner will have less tolerance for accepting the risk of investing in this stock relative to the higher earner who has a much greater ability to recover from likely short-term downturns.
Existing Portfolio Size: This factor is related to income/earning capacity and is primarily related to an individual’s ability to take risks. All else the same, an individual with a large portfolio is able to hold a wider array of asset types—meaning they can hold a more widely diversified portfolio. We haven’t introduced the concept of diversification yet, but for now, what’s important is that diversification helps mute the volatility of individual stocks or specific asset classes. However, we need to be very careful here with our generalizations. I know people with large portfolios who are very risk averse and I know people with small portfolios who are very risk tolerant.
Financial Goals: Your financial goals directly impact the time horizon or holding period of your investments, so while this isn’t necessarily a separate factor that impacts risk tolerance, it’s a critical determinant of time horizon and should be highlighted. Financial goals can be things like saving for college, a home purchase, retirement, and/or the purchase of a business just to name a few.
Knowledge and Skill: The more experience you have with economics, money, and investing, the more comfortable you’ll be analyzing the risk-return profile of an investment. This improvement in knowledge and skill will yield better economic decisions, which will lead to improved performance, which will help build more confidence in your ability to reap the rewards riskier investments can offer.
Stress Tolerance: Although we’ve already discussed self-confidence and self-esteem, our ability to process stress can have a tremendous impact on our willingness to take risks. The general rule is this. If holding an investment is keeping you up at night, it’s likely not the right investment for you. Like most things in life, this is a balancing act. There is no growth without discomfort, so if you have high stress levels (low stress tolerance) and lose sleep over risky investments, then a less risky, lower expected return portfolio is likely the better option for you. In investing, to “know thyself” and invest accordingly is extremely important. Your peace of mind matters.
So that’s where we’ll leave it for today. See you next week for more financial literacy lessons.
Grace. Dignity. Compassion.
