You’ve probably heard of risk tolerance, and maybe you’ve even received a score or a label for yours. So, what is risk tolerance, and how can you use it to build a better portfolio?

Risk tolerance is an investor’s ability to take on risk in order to pursue gains. There is ample evidence that a well-designed portfolio with a higher level of risk is likely to outperform a well-designed but less-risky portfolio, particularly over the long run. However, it is often the case that investors with portfolios with too high a level of risk will actually do the worst of all (more on that later)!

Think about it this way: you might be very happy to lend Google some money—i.e. buy a Google bond—in return for a promise of a 6% annual interest payment. However, if some new startup business in town asks you to lend them some money, you’d be smart to insist on a much higher interest rate than 6%, because it is clearly a much riskier loan, and you should expect to be paid more for a riskier investment.

This same concept holds for stocks: when you are investing in riskier companies or areas of the markets, you expect a premium on your returns. More risk, more return, or at least an investor would hope.

Where it can all go wrong is if your portfolio’s level of risk is higher than your risk tolerance. In that case, when the market hits a downturn you are at substantial risk of selling some or all of your investments. That’s because you are not built to handle the level of price volatility that your investments are experiencing, so you panic, lose sleep, or second-guess your portfolio. If you remember nothing else from this column, remember that selling stocks when they are down is a great way to lose money and prevent yourself from sharing in future market gains!

You can also hurt portfolio returns if your portfolio is too conservative. After all, the more conservative your portfolio, the lower the expected returns are likely to be. So if you are in a portfolio that is of lower risk than you are ready for, there’s a good chance you’re earning lower returns as a result.

Much like the ski slopes are designated by green, blue, and black markers to indicate the level of difficulty, investment portfolios are designated as “conservative”, “moderate” and “aggressive”. These names identify the range of allocations to different asset classes and areas of the market, and they should match up with the risk tolerance of the investor; a conservative portfolio will typically have more bonds (lower risk) than equities (higher risk), for example.

There are short quizzes that you can take to get scored on your risk tolerance. A company called “Nitrogen”, formerly Riskalyze, has one that is popular with financial advisors and their clients, who are scored on a scale from 0-100. YourStake is another company with a similar scoring system. A good investor needs to understand his or her own ability to tolerate risk in order to maximize success.

Of course, your portfolio design should depend on more than just your risk score. Your age, how many years before you expect to need your money and your financial situation are just a few other pieces of the puzzle. A good financial advisor should be gathering this information from you in order to construct the best and most appropriate portfolio.

Understanding your risk tolerance can help you invest with confidence while avoiding the kinds of emotional decisions that can wreck your portfolio returns.

However you choose to build your risk-appropriate portfolio, invest smartly and invest well!

Larry Sidney is a Zephyr Cove-based Investment Advisor Representative. Information is found at https://palisadeinvestments.com/ or by calling 775-299-4600 x702. This is not a solicitation to buy or sell securities. Clients may hold positions mentioned in this article. Past Performance does not guarantee future results. Consult your financial advisor before purchasing any security.