Estimating Investment Allocations based on Risk Tolerance
This calculator can be used to estimate the percentage of an investment portfolio held in common stock, bonds, and cash based on a risk tolerance score. The calculator needs answers to a total of six questions, including:
- How many years does the investor have until the retirement
- Whether or not the investor is comfortable with the stock market
- What action would be taken if an investment were to decline by 20%
- The investor’s level of knowledge / experience
- How comfortable the investor is taking on risk
- What is the acceptable gain or loss on an investment of 1,000
The calculator then provides the user with two sets of outputs, including:
- The investor’s risk tolerance score, which ranges from a low of 6 (risk averse) to 20 (risk tolerant)
- A description of the investment portfolio strategy, such as Preservation, Conservative, or All Stocks
- An estimate of the percentage of the investment allocated to each of stock, bond, and cash
Asset Allocation and Risk Tolerance
An investor’s risk tolerance score reflects the level of risk an investor is willing to assume or tolerate. It is their ability to withstand potential losses, which are often associated with investments such as common stocks. It’s also been defined as someone’s loss aversion, which is their fear of potential losses.
Risk tolerance and asset allocation go hand-in-hand because risk averse investors will want to hold a greater proportion of their portfolio in safe investments such as cash, since preservation of capital is important to these investors. Some investors will be willing to assume more risk for potentially greater rewards. The portfolios of these individuals will have a larger proportion of investments in common stocks.
The questions asked to determine a person’s risk tolerance are standardized and the resulting asset allocation is meant to be a guide. Each investor must decide for themselves the proper asset allocation strategy based on their individual goals. Our calculator has the following five asset allocation / risk tolerance break points:
- Preservation: includes risk tolerance scores from 6 to 7, resulting in a recommended preservation portfolio consisting of 60% bonds and 40% cash
- Conservative: includes risk tolerance scores from 8 to 9, resulting in a recommended conservative portfolio consisting of 20% stocks, 48% bonds, and 32% cash
- Moderate: includes risk tolerance scores from 10 to 12, resulting in a recommended moderate portfolio consisting of 40% stocks, 36% bonds, and 24% cash
- Growth: includes risk tolerance scores from 16 to 18, resulting in a recommended growth portfolio consisting of 80% stocks, 12% bonds, and 8% cash
- All Stocks: includes risk tolerance scores from 19 to 20, resulting in a recommended portfolio consisting of 100% stocks
Risk Tolerance Over Time
The very first question used by the calculator to estimate the investor’s risk tolerance score has to do with the number of years until retirement. Individuals with at least 25 years to go before retirement, even if risk averse in all their other responses, will have a recommended Conservative portfolio, which contains 20% stocks. Timing is an important consideration for two reasons. The first has to do with the ability to recoup losses in the event of a bear market. If an investor has less than 10 years before retirement, a portfolio consisting of 100% stocks is not a suitable recommendation. The second timing issue has to do someone’s change in their comfort, experience, and knowledge of riskier investments, such as common stock, over time. That’s why it’s a clever idea for investors to use a calculator such as this one from time to time to see if their risk tolerance has changed in either direction; thereby warranting a change in their asset allocation approach too.