A Risk Tolerance Test
Teaching Tool 16 - A Risk Tolerance Test
Personal Finance: Another Perspective
Introduction
Investing is a challenging topic. The key to investing is understanding the principles which
should drive your investment decision which we have discussed in class. They are: Know
yourself; understand risk; stay diversified; invest low-cost and tax-efficiently; invest long-term;
know what you invest in and who you invest with; monitor performance versus benchmarks;
don’t waste too much time, energy and money trying to beat the market unless you have lots of
time, energy, and money; invest only with high-quality individuals and institutions; and know
your goals, budget, and have a well written investment plan that you follow. If you follow these
principles in the development, construction, and monitoring of your investments, there is a much
greater chance that you will have a successful portfolio which will help you to reach your
personal and investment goals.
Know Yourself
In the principles “knowing yourself and understanding risk,” it is important to understand how
much risk you are willing to take. This is a difficult and time-consuming activity. To help you
in this process, I have put together this risk tolerance test. There are lots of different risk
tolerance tests available, and consider this as just one of many. Generally, firms will have their
own test, with the goal of having you invest in their products. We have no biases here. The goal
is only to help you understand yourself--we have no mutual funds or assets to sell.
How you create your investment plan is affected by many different variables. Your emotional
make-up plays a significant role. Intellectually, you may agree that stocks and bonds should be a
major part of your portfolio. Emotionally, however, you may not be comfortable with the
sometimes wild ride of the stock and bond markets. Moreover, your income, your emergency
fund, your current investments, your investment experience—all these have an impact on your
willingness to tolerate risk. What should you do?
Risk tolerance varies from one investor to the next. Indeed, two individuals with identical
investment objectives, time frame, and financial resources may each have a very different
willingness to tolerate risk. There is no simple scale to measure your tolerance (or intolerance)
for risk. Likewise, there is no set of clear-cut terms which mean the same to all investors.
Understanding Risk Tolerance
Defining your personal risk tolerance level is important. It will allow you to build a portfolio
that is the most suited to help you reach your future goals while allowing you to invest within
your comfort zone, i.e. building a “sleep-well” portfolio. This short test may offer some insight
as to your feelings toward risk. It will also rank some of the common factors that determine your
ability to take on risk. These factors include age, income, current savings and general investment
knowledge. Note however that this is just one test, and an imperfect one at that.
- Page 1 of 8 -
A Risk Tolerance Test
Realize that there is no one-size-fits-all risk tolerance test. I have put the following test together
to give you general guidelines to help you understand yourself and your tolerance for risk. I
strongly suggest that you take a number of other risk tolerance tests, and compare the results
with what you find here. It will likely be an eye-opening experience. Another purpose of this
risk tolerance test is to help you as you work to determine your asset allocation targets for your
investment plan.
Your Goal: Asset Allocation
The purpose of this risk tolerance test, in addition to understanding your tolerance for risk, is to
help you as you determine an asset allocation target that you can use for your investment plan.
Realize that determining your asset allocation targets is one of the most important determinants
of portfolio return, and as such, it should be done carefully.
There is a three step process for determining your asset allocation targets: (1) Determine your
initial allocation between stocks and bonds (and cash). (2) Take a risk tolerance test, which will
help you adjust that initial allocation consistent with your ability to tolerate risk. (3) Based on
that risk tolerance test, make your final allocations of asset classes within stocks and your final
allocation of asset classes within bonds and cash.
Step 1. Determine your initial asset allocation. There is a general rule of thumb used in the
financial planning industry that as an initial allocation for investing, you begin with your age in
bonds. The logic is this: as investors get older, generally they will have less willingness to
accept risk, and the higher bond allocation is representative of that lower risk level. Younger
investor’s generally have a longer time horizon, and hence, can have a higher allocation to more
risky asset classes, such as equities.
Step 2. Take a risk tolerance test and adjust that initial allocation. Once that stock and bond
initial allocation is determined, the next step is to adjust that bond allocation based on your
individual risk tolerance. This risk tolerance test offers the second part of that allocation process.
By taking this test, it can help you determine what your asset allocation should be based on your
responses to each of the questions. The result of this risk tolerance test is an adjustment to that
initial bond and stock allocation.
Step 3. Allocate within each of the major asset classes: stocks and bonds and cash. The final
step is to determine which asset classes within stocks (i.e. large capitalization, mid-cap, smallcap, International, Emerging Markets, REITs, hedge funds, etc) should be included in your stock
asset allocation, and which asset classes within bonds and cash (, i.e., government bonds (short- ,
medium- and long-term), corporate bonds (short-, intermediate-, long-term), junk bonds, etc.)
should be included in your asset allocation targets.
The general ideas and questions for this test were taken from the Arkansas Lawyer Magazine,
Spring 2002 from the website: http://www.arkbar.com/Ark_Lawyer_Mag/_notes/401(k)_Spring02.htm.
- Page 2 of 8 -
A Risk Tolerance Test
Risk Tolerance Questions:
1. Age: What is your age?
1. 65 and over
2. 45 to 64
3. 35 to 44
4. 25 to 34
5. 24 and under
The younger you are generally, the more willing you should be to tolerate risk. If you are
younger, you have a longer time horizon in which to grow assets. Generally, over the
longer term, assets invested in the stock market have outperformed other asset classes.
So if you are younger, should think about taking a little more risk. A general rule of
thumb is that you should include bonds in your portfolio equal to your age.
2. Time Horizon: What is your investment time horizon for this money?
1. 1 year
2. 2-5 years
3. 5-10 years
4. 10-20 years
5. 20 years or longer
While you will have different time horizons for different “buckets” of money, you should
remember that money in the stock market is subject to more risks. Generally, if your
time horizon is less than 3-5 years, it may not be a good idea to invest a sizeable amount
in the stock market. You time horizon will have an impact on how much risk you are
willing to take.
3. Investment Goals: What is your primary objective for this money?
1. Preservation of Principal
2. Current Income
3. Growth and Income
4. Conservative Growth
5. Aggressive Growth
Your goals and budget seem to drive most areas of personal finance. Depending on your
goals, it will make a big difference on where you invest your assets. If your goal is safety
of principle, you should be willing to take on very little risk. Therefore, you should
invest accordingly. If your goal is aggressive growth, you should be willing to take on
much more risk. Your goals will, to a degree, drive your willingness to take on risk.
- Page 3 of 8 -
A Risk Tolerance Test
4. Personal Earnings: Regarding your current income, do you expect it to:
1. Decrease dramatically in the future
2. Decrease a slight amount in the future
3. Stay about the same
4. Increase with the pace of inflation
5. Increase dramatically
Your income is an important driver of your investment program. If you feel your income
will decline in the future, you will likely be much less willing to tolerate risk than if you
think your income will increase dramatically. So your expectations of your earning
ability will have an impact on your portfolio and risk.
5. Emergency Fund: What amount of money do you have set aside for emergencies?
This does not include borrowings or credit lines, but does include money in checking and
savings accounts, CDs, money market funds, and assets in no-load open-end mutual
funds that you can access quickly in case of an emergency.
1. None
2. Enough to cover three months of expenses
3. Enough to cover six months of expenses
4. Enough to cover nine months of expenses
5. Over twelve months of expenses
The more money you have that can be used as an emergency fund, the more you are able
to take on additional risk. Generally, with your first investments, you should take on very
little risk. As your asset size increases, so should your willingness to increase your level
of risk.
6. Investment Experience: Which statement best describes your personal investment
experience?
1. I have never invested any money in any financial market or instrument.
2. I am relatively new investor, having invested for only a few years.
3. I have invested some of my money through IRAs and through employer
sponsored retirement plans (401 (k)) for quite some time, but now I am ready to
develop additional investment strategies outside of that plan.
4. I have invested for quite some time and am fairly confident in my ability to
make prudent investment decisions.
5. I have invested money for years and have a definite knowledge of how the
stock and bond financial markets work.
Generally, the more experience investors have with the financial markets, the more risk
they are able and willing to bear. However, this should be tempered by your willingness
to accept risk.
- Page 4 of 8 -
A Risk Tolerance Test
7. Investment Risk: Regarding your view of risk, which investment would you be more
comfortable making?
1. I am comfortable investing in savings accounts, CDs, and other short-term
financial instruments that are FDIC Insured.
2. I invest in savings accounts and CDs, but I also own various income-producing
bonds and/or bond mutual funds.
3. I have invested in a broad array of stock and bond mutual funds, but only the
highest quality.
4. I have invested primarily in growth stocks and growth stock mutual funds.
5. I like to pick out new and emerging growth companies and aggressive growth
stock mutual funds.
For most investors, a look at what they are invested in now may be a good indication of
their willingness to take on risk. If they are invested only in CDs and other “safe”
instruments, they are likely not willing to take on much risk. If they are investing in
aggressive stocks and mutual funds, that indicates they are willing to take on much more
risk.
8. Investment Preferences: Which investment would you be more likely to invest in?
1. This investment has a 20-year average annual return of 2%. It has achieved
those returns with infrequent and very slight downturns. This investment has
never experienced a negative return.
2. This investment has a 20-year average annual return of 4%. It has achieved
those returns with mostly positive returns, although there have been periods of
less than a year of negative returns.
3. This investment has a 20-year average annual return of 6%. It has achieved
those returns with a few moderate downturns where the decline lasted less than
six months and then began to recover. It has experienced more than one-year of
negative returns.
4. This investment has a 20-year average annual return of 8%. It has achieved
those returns with several periods of above average returns and several periods of
negative returns
5. This investment has a 20-year average annual return of 10%. It has achieved
those returns while cycling through several periods of substantially above average
returns and several periods of substantially negative returns.
Generally, higher returns require higher risk, which in this case is the possibility of
having several years of negative returns. If you are comfortable with lower returns and
lower chances for negative returns, you should position your portfolio accordingly. If
you want the higher returns and are willing to take on the higher risk, likewise invest
according to your willingness to accept risk.
- Page 5 of 8 -
A Risk Tolerance Test
Your Risk Score
Step 1. The initial asset allocation determination is the easiest, it is your age in bonds. If
you are 25 years old, your beginning point would be your age in bonds or 25% in bonds.
The remainder of your portfolio would be in equities.
Step 2. The second step is to adjust your initial allocation based on the results of this risk
tolerance test. To calculate your score, simply add up the points from each of the
questions. You will receive one point for each number that you circled. For example, if
you circled a 1 as an answer to question 1, you receive one point. If you circled a 4, you
receive four points. Add all the points together from all the questions, and it will put you
into a specific category, i.e. very conservative, conservative, moderate, aggressive, and
very aggressive.
As you see which category you are in, you will notice that below each category is an
adjustment to that initial asset allocation. If your risk category is “Very Conservative”,
you would notice that your adjustments to your initial allocation would to be increase
bonds and cash by roughly 20%, and reduce your equities by 20%. At age 25 with this
risk level, the results suggest an allocation of 45% bonds and 55% equities. At age 50,
with this risk level, it suggests and allocation of 70% bonds and 30% equities. Notice
that your age has a major impact on your allocations. Two different investors with
different risk tolerances and ages could have the same allocations. For example an age
25 very conservative investor and an age 45 moderate investor would have the same
allocations.
Step 3. The final step is to review your “Risk Tolerance Category”, and with that
knowledge, allocate between the various asset classes within stocks and within bonds. If
you are “very conservative,” you would invest the majority of your allocations in the
least risky asset classes within stocks, mainly large capitalization stocks. For purposes of
diversification, you might have a small allocation, say 5 to 10% of your stock allocation
to be invested each in small capitalization or international stocks. Likewise you would
invest the majority of bond assets in the least risky categories of bonds, i.e. money market
mutual funds, treasury securities, and corporate bonds.
These questions and this scoring scale is not meant to be used for anything other than as a
general guide to how much risk you are willing to take and to help you in your stocks
versus bonds and cash allocation. Your actual investment plan may and should be based
on additional information that was not asked in this questionnaire, as well as weighting
information on which of the above questions are more important to you. While it is not
exact, it may be helpful as you create a portfolio of investments that matches your asset
allocation to your risk tolerance level.
- Page 6 of 8 -
A Risk Tolerance Test
Risk Tolerance Results
Risk Tolerance Category
Points
Asset Classes:
Adjustment to the initial asset class weights
1. Very Conservative
Cash
Bonds
Stocks
(8 to 12 points)
+5%
+15%
-20%
2. Conservative
Cash:
Bonds:
Stocks:
(13 to 20 points)
+0%
+10%
-10%
3. Moderate
Cash
Bonds
Stocks
(21 to 28 points)
0%
0%
0%
4. Aggressive
Cash
Bonds
Stocks
(29 to 36 points)
-5%
-5%
+10%
5. Very Aggressive
Cash
Bonds
Stocks
(37 to 40 points)
-5%
-15%
+20%
* Investors are free to shift between the cash and bond allocations without any change in
effectiveness of the test. I personally prefer to always have, at minimum, a 5% allocation
to cash.
Disclaimer
The purpose of this material and this class is to help you get your financial house in
order and to help you on your road to financial self-reliance. If there are mistakes in this
material, please bring them to our attention, and we will correct them in upcoming
- Page 7 of 8 -
A Risk Tolerance Test
versions. The teacher, and BYU, specifically disclaim any liability or responsibility for
claims, loss, or risk incurred, directly or indirectly, by using this material.
- Page 8 of 8 -