What is Risk Tolerance? How is it Measured?
When investing, risk and reward go hand in hand. Some investors are willing to take on more risk if there is a potential for greater reward, while others prefer to invest in more stable and secure investments even if it provides only a moderate return. This is called an investor’s risk tolerance.
Risk tolerance plays an important role in creating an investor’s profile and determining an investment strategy.
Risk Tolerance Definition
Risk tolerance refers to an investor’s ability and willingness to handle a decline in the value of their investments. When determining risk tolerance, ask yourself how comfortable you will feel maintaining your positions when the stock market is experiencing large downturns.
Risk Tolerance vs. Risk Capacity
While risk tolerance measures an investor’s willingness to take risks, an investor’s risk capacity measures their financial ability to take a risk.
While these two concepts are linked, they are not necessarily the same thing. Some ultra-wealthy investors, and even accredited investors, end up having low risk comfort levels regardless of their high capacity for risk. On the other hand, some investors may be willing to take on more risk than would be recommended based on their financial situation.
Understanding Risk Tolerance
All investments carry some degree of risk. Understanding their risk tolerance and your own comfort level can help with the financial planning of your entire portfolio.
Risk vs. Return
One fundamental idea behind a lot of investment decisions is the relationship between risk and return. “High-risk, high return” is a common mantra on Wall Street, referring to the idea that the greater amount of risk an investor takes on, the greater the potential return on their investment.
This can be seen most plainly in fixed income pricing. U.S. Treasury bonds are considered one of the safest investments because they are backed by the full faith of the U.S. government, but they also provide some of the lowest rates of return.
Outside of government and municipal bonds, corporate bonds are priced as either “investment-grade” or “high-yield.” Investment-grade bonds have a higher credit rating, meaning less likelihood of default, while high-yield bonds have a higher likelihood of default but offer higher coupon rates. Investors willing to take on more risk are rewarded with the potential for higher returns.
It’s important to note that while there is a general tradeoff between risk and reward, higher risk doesn’t automatically guarantee higher returns. The tradeoff only indicates that higher-risk investments have the potential for higher returns. There is still always the very real possibility of losing some or even all of your principal investment.
Types of Risk Tolerance
It’s easy to have a high risk tolerance when markets rise. On the other hand, you may find yourself uncomfortable taking the same level of risk during bear markets. That is why down markets are the best time to assess your own tolerance.
In the current market, as stocks are falling and inflation is on the rise, some investors are willing to hold while others have sold off. That is due to the investor’s own risk tolerance. Some are more willing to take advantage of sell-offs while others don’t invest during down markets.
Based on how much risk they can tolerate, investors are classified as conservative, moderate or aggressive.
Conservative Risk Tolerance
Investors focused on the preservation of capital and cautious of downside risk would be considered conservative investors. These investors are willing to accept little to no fluctuations in their investment portfolios.
Typically, individuals working towards a short-term goal or approaching the end of long-term goals are more likely to be conservative investors. For example, retirees or those close to retirement age are often included in this category as they may be unwilling to risk a loss to their principal investment.
The shorter your investment time horizon, the less risks you will generally make because there is less time available to make up for any potential losses. There is more pressing need to just preserve capital that is about to be used.
Conservative investors typically target investment products that are guaranteed and highly liquid. Risk-averse individuals often opt for bank certificates of deposit (CDs), money market accounts, investment grade fixed income or U.S. Treasuries.
Moderate Risk Tolerance
Most investors tend to fall into the moderate risk profile. These investors want to grow their money without losing too much. Their goal is to weigh opportunities and potential losses in order to mitigate investment risk but still take enough to earn returns.
Generally, moderate investors create an investment strategy that emphasizes diversification across various asset classes to minimize risk while still investing in higher-yield products.
Aggressive Risk Tolerance
An aggressive investor, or one with a high-risk tolerance, is willing to lose money to get potentially better returns. Aggressive investors tend to be more sophisticated investors with an understanding of market volatility and follow strategies for achieving higher-than-average returns.
Investors comfortable taking on a high level of risk typically emphasize capital appreciation rather than income or the preservation of wealth. This investor’s asset allocation can vary quite a bit, but they commonly invest in more high-risk products such as alternative investments, emerging markets and stocks as opposed to safer financial products like bonds or cash.
Why is Risk Tolerance Important?
Determining your own personal risk profile is important for making investment decisions that can help you reach investment goals without adding undue stress.
If risk tolerance isn’t considered when making investment decisions, investors can end up losing more than they were willing to and can harm investment goals. It’s important to know how to react when the value of investments falls. Many investors sell off during downturns, leading to massive losses. At the same time, a market decline can be a great time to buy.
Therefore, determining your risk profile helps make informed decisions regarding which investment products to invest in, where to invest and how to react during downturns.
How to Determine Risk Tolerance
An individual’s risk tolerance will be based on factors such as age, income, investment goals, liquidity needs, time horizon and even personality. Working with a financial advisor can help investors meet their investment objectives while keeping their risk profile in mind.
If an advisor is not for you, there are many investment websites that offer free questionnaires to help you assess your risk tolerance. Common factors used to determine client risk tolerance include:
Time Horizon & Age
Each investor has different time horizons based on their own investment plans. Generally, more risk can be taken if there is more time because market swings don’t directly harm the potential for continued growth. That’s because the market has shown an upward trend over the long-term, but short-term losses occur often.
An individual who needs a certain sum of money at retirement 30 years from now can take more risk than an individual who needs the same amount by the end of five years.
Age plays a large role in risk tolerance and time horizon, but they’re not exactly the same.
Some young individuals may be investing for a down payment or their child’s college tuition, while other young individuals may solely be investing for retirement. It’s not always true that younger investors have longer time horizons and therefore more aggressive risk tolerances.
Financial goals vary from person to person. The main goal of most investors is not just to accumulate the highest amount of money possible. Typically there is a dollar figure goal determined and an investment strategy developed to deliver such returns.
The amount of money you are looking to accumulate impacts the degree of risk you are willing to take on.
The larger the portfolio, the more wiggle room there is to take risks. An investor with a $50 million portfolio can typically tolerate more risk than an investor with a $1 million portfolio. If the value of an investment drops, the percentage loss is much less in a larger portfolio compared to a smaller portfolio.
Also, larger portfolios are generally held by investors with more financial freedom in general. Investors with the ability to hold $50 million in investments will tend to have more flexibility in general compared to an investor with a smaller portfolio size.
An investor’s future earning potential also plays a role here, along with the presence of other assets such as real estate, a pension, Social Security or an inheritance. Investors can take on more risk when they have other, more stable sources of funds available.
Investor Comfort Level
Each investor has a different personality. Some investors are natural risk-takers who enjoy the rush of potential gains and can tolerate the pain of losses. Other investors are naturally cautious, despite any other factors listed above, and may not want to take on any additional risks to their principal.
At the end of the day, risk tolerance refers to an investor’s willingness to take on risk. Therefore, more than any other factor, risk tolerance is directly related to how comfortable investors are with potential loss.
The Bottom Line
Every individual has their own risk tolerance, and that tolerance can change over the course of their life depending on life circumstances and market conditions.
Understanding your own comfort level with potential losses and types of risks associated with investment products can help you create a sustainable investment strategy.
This material is provided for informational and educational purposes only. It is not intended to be investment advice and should not be relied on to form the basis of an investment decision