Introduction of Risk Tolerance
Risk tolerance is the ability of the investor to withstand the loss from the investments. It refers to the risk appetite of the investor and the amount of loss an investor can afford to accept. The higher the risk, the higher is the returns and the investor with more risk tolerance is ready to risk the money for better returns.
Risk tolerance can be measured based on the capacity and willingness of the investor to take the risk and how much an investor can afford to take the loss. Risk tolerance is a key concept in investing. All investment decisions can be taken only after considering the risk tolerance of the investor. Risk tolerance is associated with various factors like the age of the investor, investment goals, net worth, and financial position of the investor, period of investment, etc.
In general investors of young age have high-risk tolerance compared to the old age investors, the investors with a long-time horizon will be willing to greater risk compared to those who have a short time horizon. Investors with more risk tolerance generally choose investments like equities, Exchange-traded funds, etc. whereas investors with low-risk tolerance predominantly choose to invest in secured investments or fixed-income investments like bonds, deposits, treasury bonds, etc. But the age of the investor and time horizon doesn’t matter for investments only when the investor is backed by a strong financial background and they can afford to take the risk in investing.
Examples of Risk Tolerance
Mr. X is retiring in another 2 months. He is looking for the right 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 main categories based on risk tolerance. The three categories are:
1. Aggressive Risk Tolerance
Aggressive risk tolerance investors are usually well knowledgeable about the market and the risk associated with it. These investors are used to the ups and downs in the securities value of the portfolio based on the market movements. They are experienced and have the ability to 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 there is the market is not doing well and these investors are used to these price fluctuations and they can manage it.
2. Moderate Risk Tolerance
Moderate risk tolerance investors accept risk in investments to some level and it is less compared to the aggressive risk investors. They benchmark a limit up to which they are okay to bear the loss. Usually, these investors strategize to reduce the risk by investing both in risky investments like equities and safe investments like fixed-income securities. They usually adopt50:50 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 the financial instruments/ securities where their investment capital is protected. They choose to avoid loss and risk rather than aiming for more returns. They predominantly invest in safe investments like deposits, PPF, bonds, etc. These investors enjoy decent returns from low-risk investments.
Factors of Risk Tolerance
Every individual investor’s risk tolerance is determined by various factors. The following are some of the key factors for determining risk tolerance.
- Investment Goals: The Investment goals of the investor play a major role in risk tolerance. If an investor wants to make more money in a short span of time, then they choose to go for high-risk investments. Their risk appetite will be more as they are expecting more returns. An investment strategy can be formed based on individual investment goals.
- Period of Investment: If an investor plans for a long-term investment, then they have more time to carry the investment. Whereas 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 invests for short-term may choose low-risk investments.
- Age of the Investor: The Investor who are at a young age generally has a long time for investment and they have more risk appetite compared to investors who are little old, and their purpose of investment is to secure their retirement funds or who expects to have a fixed-income post-retirement. Young investors can afford to take more risks whereas people at retirement age or above tries to go for a secured investment.
- Portfolio Size: Investment size matters in determining risk tolerance. An investor who has a big portfolio can afford to take more risk compared to a small investor who just started investing or if their portfolio value is low. Small investors don’t enjoy the leverage benefits as big portfolio investors.
- Comfort Level: Personal comfort and financial comfort matter a lot in deciding the investment plan and risk tolerance. An investor by nature can be risk-averse and naturally choose low-risk investments whereas there can few aggressive investors who love to take the risk and enjoy returns. The financial status of the investor also matters a lot in the choice of investment, a person with a normal financial status avoids risk and goes for safe investments.
Benefits of Risk Tolerance
Some of the benefits are given below:
- Knowing risk tolerance helps the investor in deciding their investment plan and guides them to choose the right investment based on their ability to handle the risk and losses.
- Assessing risk tolerance is important to form an investment strategy and to handle the investments safely.
- Investments made without assessing the risk tolerance can cause financial troubles to investors if they are not capable to handle the losses.
Risk tolerance is decided based on the investor’s ability to accept the losses when their investments perform poorly. If the tolerance is low, then the investor chooses to invest more in low-risk investments and less in high-risk investments. An investment plan and strategy can be formed only after assessing the risk tolerance of the investor. Investment goals are predominantly determined based on risk tolerance.
This is a guide to Risk Tolerance. Here we also discuss the introduction and types of risk tolerance along with benefits and examples. You may also have a look at the following articles to learn more –