Updated July 17, 2023
Introduction of Risk Tolerance
Risk tolerance is the ability of the investor to withstand the loss from the investments. It refers to the investor’s risk appetite and the loss an investor can afford to accept. The higher the risk, the higher the returns, and the investor with more risk tolerance is ready to risk the money for better returns.
Risk measurement can be based on the investor’s capacity, willingness to take risks, and affordability to bear potential losses. It is a critical concept in investing. All investment decisions can be taken only after considering the investor’s risk tolerance. It is associated with various factors like the investor’s age, investment goals, net worth, financial position, period of investment, etc.
In general, investors of young age have high-risk tolerance compared to old-age investors; investors with a long-time horizon will be willing to take greater risk than those with a short-time horizon. Investors with more risk tolerance generally choose investments like equities, Exchange-traded funds, etc. In contrast, low-risk tolerance predominantly decides to invest in secured or fixed-income investments like bonds, deposits, treasury bonds, etc. But the investor’s age and time horizon doesn’t matter for assets only when a solid financial background backs the investor, and they can afford to take the risk in investing.
Examples of Risk Tolerance
Mr. X is retiring in another two months. He is looking for a suitable investment for his retirement funds. He is looking for a stable fixed income post-retirement and wants to invest in a low-risk financial instrument.
In the given case, Mr. X can choose to invest in instruments like certificates of deposit, treasury bonds, etc., where the investment is secured, and also, he can get fixed income from the securities. In this case, the risk tolerance of Mr. X is low, so he chose a low-risk investment.
Types of Risk Tolerance
Investors are classified into three categories based on their risk tolerance. The three categories are:
1. Aggressive Risk Tolerance
Aggressive risk tolerance investors know the market and its risk well. These investors actively experience the ups and downs in the securities value of their portfolio based on market movements. They actively possess experience and can withstand the risk associated with the investment.
They predominantly trade in securities where there is an opportunity for more returns (e.g.) Stocks. They trade in high-risk securities in turn for better returns. There can be chances where they can make good returns when the market performs well; at the same time, they can incur huge losses if the market is not doing well, and these investors are used to these price fluctuations and can manage it.
2. Moderate Risk Tolerance
Moderate risk tolerance investors accept risk in investments to some level, less than aggressive risk investors. They benchmark a limit to which they can bear the loss. Usually, these investors strategize to reduce the risk by investing in risky investments like equities and safe investments like fixed-income securities. They usually adopt 50:50 proportions to reduce the risk and have decent returns. These investors may not earn as aggressive risk investors, but at the same time, they may not incur much loss when the market performs poorly.
3. Conservative Risk Tolerance
Conservative risk tolerance investors take the least risk in the market. They don’t go for risky investments and choose to invest in financial instruments/ securities where their investment capital is protected. They decide to avoid loss and risk rather than aiming for more returns. However, they predominantly invest in safe investments like deposits, PPF, bonds, etc. These investors enjoy decent returns from low-risk investments.
Factors of Risk Tolerance
Various factors determine every individual investor’s risk tolerance. The following are some of the critical factors for deciding it.
- Investment Goals: The investor’s Investment goals play a significant role in risk tolerance. Investors who want to make more money quickly choose high-risk investments. Their risk appetite will be more as they are expecting more returns. Individual investment goals actively serve as a foundation for developing an investment strategy.
- Period of Investment: If an investor plans for a long-term investment, they have more time to carry it. At the same time, few people invest only for the short term. So, they choose to invest in securities and financial instruments based on how long they want to hold their investment and what returns they expect. A long-term investor may choose high-risk investments, whereas investors who invest in short-term may choose low-risk investments.
- Age of the Investor: Investors at a young age generally have a long time to invest and have more risk appetite compared to investors who are a little old and their investment purpose is to secure their retirement funds or expect to have a fixed-income post-retirement. Young investors can afford to take more risks, whereas people at retirement age or above try to go for a secured investment.
- Portfolio Size: The size of an investment is essential in determining risk tolerance. An investor with an extensive portfolio can afford to take more risk than a small investor who just started investing or if their portfolio value is low. Small investors don’t enjoy the leverage benefits of big portfolio investors.
- Comfort Level: Personal and financial comfort greatly complicates the investment plan and risk tolerance. An investor can be risk-averse and naturally choose low-risk investments, whereas there can be few aggressive investors who love to take the risk and enjoy returns. The investor’s financial status also matters a lot in the choice of investment; a person with a legal and financial status avoids risk and goes for safe investments.
- Knowing it helps the investor decide on their investment plan and guides them to choose the suitable investment based on their ability to handle the risk and losses.
- Assessing risk tolerances is essential for forming an investment strategy and safely handling investments.
- Investments made without assessing the risk tolerances can cause financial troubles to investors if they cannot handle the losses.
It is decided based on the investor’s ability to accept the losses when their investments perform poorly. If the tolerance is low, the investor chooses to invest more in low-risk and less in high-risk investments. Assessing the investor’s risk tolerances actively forms the basis for developing an investment plan and strategy. Investment goals are predominantly determined based on risk tolerances.
This is a guide to Risk Tolerance. Here we also discuss the introduction, types, benefits, and examples. You may also have a look at the following articles to learn more –