Determining Your Risk Tolerance for 403(b) Plan Investing
July 12, 2025
By Barbara O'Neill, CFP®, AFC®
There are five key decision points that all 403(b) plan investors face:
- Whether to invest for retirement in a 403(b) or elsewhere (e.g., a Roth IRA) or not at all
- How much of your pay to invest (from an employer’s required minimum to the IRS annual maximum)
- What 403b plan vendor to select (ideally, a 403bwise Green + vendor with low expense choices)
- What investments to select from among those available through the selected vendor
- What 403(b) plan revisions are periodically needed (e.g., change of vendor or contribution percentage)
This post focuses on investment decisions, specifically, the role investment risk tolerance plays in choices that plan participants make. It begins with an overview of investment risks and risk reduction strategies followed by a discussion of investment risk tolerance, asset allocation decisions, and the impact of having a pension on portfolio asset allocation. A frequently used Investment Risk Tolerance Assessment tool is also described.
Also included is a summary of several research studies about investment risk tolerance. The post concludes with three “need to know” facts, and six take-away action steps.
Investment Risks
All investments have one or more types of risk. There is no such thing as a “perfect investment” that is risk-free and guarantees a high tax-free return. Risks vary for different types of investments. Causes of investment risks include inflation, economic trends, political uncertainty, business failure, and interest rate changes.
Below are five common types of investment risk:
- Business risk is the risk of loss when a company has poor performance, mismanagement or, worse yet, ultimately fails. Think Enron, Borders Books, and Blockbuster Video as examples.
- Credit (default) risk is the risk of a bond issuer (government entity or corporation) being unable to make interest payments on its debt or repay investors’ principal.
- Inflation risk is common with cash equivalent assets and some bonds when their after-tax return is lower than the rate of inflation. This results in a loss of purchasing power.
- Interest rate risk is the inverse relationship between interest rates and bond prices. When interest rates go up, bond prices go down and vice versa.
- Market risk is the risk of the price of individual securities (e.g., stocks) being affected by market volatility. In other words, a stock’s price may fall simply because there is a market downturn.
Investment Risk Reduction Strategies
Two time-tested investment strategies are diversification and dollar-cost averaging. Diversification means spreading your money among different types of investments to reduce the risk of loss from a decline in any one investment. Below are six frequently used strategies:
- Place money in different asset classes (e.g., stocks, bonds, cash equivalent assets, and/or real estate)
- Choose different investments within each asset class (e.g., stock from different industry sectors)
- Purchase mutual funds and exchange-traded funds, that contain diversified portfolios of securities
- Purchase well-diversified stock and bond index funds that track broad market indices
- Purchase a lifestyle fund that includes three asset classes- stock, bonds, and cash- in varying proportions; e.g., aggressive growth (most stock), growth, moderate growth, and income (least stock) portfolios
- Purchase a lifecycle (target date) fund that manages money toward a future year (e.g., 2040) and automatically reduces the percentage of stock, and level of risk, in the fund as the target date is approached
Dollar-cost averaging is the practice of investing equal amounts of money (e.g., $100) at a regular time interval (e.g., monthly), regardless of whether the value of investments is moving up or down. A common example is the amount (e.g., 10% of gross income) that 403(b) plan participants contribute to their account each pay period. Investors acquire more shares in periods of declining share prices and fewer shares in periods of higher prices.
While research has shown that lump sum investing often produces a higher annualized return than dollar-cost averaging (DCA), many people do not have lump sums to invest. Instead, they save money from their paychecks as they earn it. DCA makes savings habitual and puts people on a path to build wealth over time.
Investment Risk Tolerance
One of the most important decisions investors can make is selecting investments that match their risk tolerance. Risk tolerance is an investor’s capacity to handle the uncertainty that accompanies the selection of specific investment products such as stocks and bonds.
Risk tolerance has been referred to as the “sleep at night factor,” as in “how much investment risk can you withstand and still be able to sleep at night?” It involves feelings and emotions as well as experiences with managing money. When people invest beyond the limits of their risk tolerance, they often experience physical symptoms of distress, including sleeplessness.
What factors affect investment risk tolerance? This question is still the subject of much research. Not all related factors are financial, however, such as income and net worth. An investor’s knowledge about investing, previous investment experience, and attitudes about risk taking in general can also influence risk tolerance.
Ideally, investors’ risk tolerance level should remain about the same during bull (rising) and bear (declining) markets. For example, if they are comfortable with the risk of loss of principal that is associated with stocks and growth mutual funds, they will feel this way whether stock market indices are rising or falling. Sadly, this is not the case and some investors panic and sell during market downturns.
Asset Allocation Decisions
Asset allocation was discussed in detail in a previous post. It is the process of dividing your money among several investment categories, called asset classes. An example is 50% stocks, 30% bonds, 10% real estate, and 10% cash assets. The objective is to lower investment risk by reducing portfolio volatility. Losses in one investment category may be offset by gains in another.
Research has also shown that asset allocation is a major determinant of investment performance. It is not what specific stock or bond you invest in that matters most over time, but, rather, the fact that you have money in different asset classes. These studies have been repeated by different researchers with similar results.
Frequently cited guidelines are “100 – your age” (conservative investors), “110 – your age” (moderate risk investors) and “120 – your age” (aggressive investors) as the suggested percentage in stocks. For example, 110 – 50 (age) = a 60% stock allocation. Aggressive investors will have more stock in their portfolio than moderate investors and moderate investors will have more stock in their portfolio than conservative investors.
These guidelines correspond with recommendations to gradually decrease the percentage of stocks in a portfolio as investors get older (rationale: to shift to more income-oriented investments and because there are fewer years left to recover from stock market downturns).
Investment asset allocation is very much like a teacher’s grade book where various exams and assignments are worth a certain percentage of a student’s grade and are all averaged together. The weighted average reflects both the rate of return earned on investments and their proportionate weight in an investor’s total portfolio.
The Pension Factor
Many 403(b) plan participants have defined benefit pensions that pay a guaranteed (and sometimes inflation-adjusted) monthly benefit based on income and years of service. If consistent with their risk tolerance level, retirees (and workers) with adequate pensions can typically afford to allocate more of their investment portfolio to stocks because a pension provides (or will provide) a stable, predictable income stream, much like a bond or annuity. In other words, the “X – your age” formulas are not especially relevant in this situation.
Guaranteed income sources reduce pressure on an investor’s portfolio to fund daily expenses, allowing them to take on more market risk. In contrast, retirees without pensions (or small pensions) must rely more heavily on their portfolio for income and may need to keep a larger portion in low-volatility assets like bonds or cash.
Investment Risk Tolerance Assessment
The Investment Risk Tolerance Assessment tool, developed by Grable and Lytton, includes 13 questions and provides users with feedback about their capacity to handle investment risk. The higher the total score, the higher (i.e., more aggressive) someone’s investment risk tolerance. Questions are based on both thoughts about risk in hypothetical situations and current investing behavior.
When online users complete the risk tolerance assessment, they receive a score and information to interpret it (i.e., to determine whether they are a conservative, moderate, or aggressive investor).
Below are two sample questions, one about a hypothetical situation and one about current practice:
You are on a TV game show and can choose one of the following. Which would you take?
- $1,000 in cash
- 50% chance at winning $5,000
- 25% chance at winning $10,000
- 5% chance at winning $100,000
In terms of experience, how comfortable are you investing in stocks or stock mutual funds?
- Not at all comfortable
- Somewhat comfortable
- Very comfortable
Source: Grable, J. E., & Lytton, R. H. (1999). Financial risk tolerance revisited: The development of a risk assessment instrument. Financial Services Review, 8, 163-181.
Research Results
Financial blogger Karl Fisch modeled investment performance scenarios and noted in a post that “many educators will be able to live in retirement completely (or almost completely) off of their pension income. Educators who know (or at least expect) that this will be the case for them should think carefully about how this might affect their investment decisions throughout their career (and even into retirement).” Translation: consider increasing equity exposure, even as high as 100%, if you have a generous defined benefit pension.
Studies have found that the risk tolerance of those who used the Investment Risk Tolerance Assessment tool, was positively associated with market indices such as the Dow Jones Industrial Average (i.e., recency bias). Respondents said they were more willing to take investment risk when markets were performing well and more reluctant to take risks during market downturns. In one study, a decrease in risk tolerance after a market high was exhibited most acutely by younger, nonmarried respondents with few investable assets.
Three (More) Things
- A conservative asset allocation over a long time period will limit portfolio growth and wealth accumulation.
- The only guarantees associated with equity investing (e.g., stocks) are uncertainty and volatility.
- Most successful investors are patient and stay focused on long-term growth vs. short-term events.
Six Smart Strategies
No. 1: Learn to Earn — Increase your knowledge of investing to understand investment characteristics and the risks involved.
No. 2: Set Boundaries — Never invest in anything that you don’t fully understand or can’t explain simply to another person.
No. 3: Think Long-Term — Maintain a long-term view and avoid reacting to daily investment performance indicators.
No. 4: Rebalance As Needed — Recalculate asset allocation weightings and rebalance, when necessary, by selling existing securities in an over-weighted asset class or putting “new money” into an under-weighted asset class.
No. 5: Piggy-Back Calculations — Combine an asset allocation analysis with a calculation of net worth. You’ll already have current figures for investment values (assets) so it won’t take much longer to determine the weights of asset classes.
No. 6: Go With Your Gut — Ask yourself “can I sleep at night?” with a particular investment or portfolio asset allocation. Keep in mind the “cushioning power” of guaranteed income sources.
In Summary
One of the most important decisions 403(b) plan participants can make is the asset allocation of their account. Investment risk tolerance affects how much risk an investor is comfortable taking. It influences asset allocation and investment decisions, balancing potential returns with acceptable levels of financial risk.
This post provides general personal finance information and does not address all the variables that apply to an individual’s unique situation. It should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.
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Dr. O'Neill is the owner/CEO of Money Talk: Financial Planning Seminars and Publications where she writes, speaks, and reviews content about personal finance. She is a Distinguished Professor Emeritus at Rutgers University and a long-time 403(b) plan participant.