Risk tolerance is defined as an investor's comfort with fluctuations in portfolio value. Which of the following is a factor that influences risk tolerance?

• A. Historical performance
• B. Market timing ability
• C. Time horizon
• D. Tax efficiency

Answer: (C)

Time horizon shapes how much risk an investor can stomach. When money is needed far in the future, you can endure short-term market swings because there’s time to recover, allowing a portfolio to include more volatile, potentially higher-return assets. If money is needed soon, you’re less able to ride out downturns, so your tolerance for volatility is lower and a more conservative allocation makes sense. So, the length of time before funds are required is a primary driver of risk tolerance.

Historical performance, market timing ability, and tax efficiency don’t determine how comfortable someone is with fluctuations. Past returns don’t set personal risk appetite, skill at predicting markets isn’t about tolerance to volatility, and tax efficiency affects after-tax results rather than how much risk you’re willing to take.