What is Risk Tolerance?
Risk tolerance refers to the amount of loss an investor is prepared to handle while making an investment decision. Several factors determine the level of risk an investor can afford to take.
Knowing the risk tolerance level helps investors plan their entire portfolio and will drive how they invest. For example, if an individual’s risk tolerance is low, investments will be made conservatively and will include more low-risk investments and less high-risk investments.
- Risk tolerance refers to the amount of loss an investor is prepared to handle while making an investment decision.
- Investors are usually classified into three main categories based on how much risk they can tolerate. They include aggressive, moderate, and conservative.
- Knowing the risk tolerance level helps investors plan their entire portfolio and will drive how they invest.
Factors that Influence Risk Tolerance
Each investor will adopt a different time horizon based on their investment plans. Generally, more risk can be taken if there is more time. An individual who needs a certain sum of money at the end of fifteen years can take more risk than an individual who needs the same amount by the end of five years. It is due to the fact that the market has shown an upward trend over the years. However, there are constant lows in the short term.
Financial goals differ from individual to individual. To accumulate the highest amount of money possible is not the sole purpose of financial planning for many. The amount required to achieve certain goals is calculated, and an investment strategy to deliver such returns is usually pursued. Therefore, each individual will take on a different risk tolerance based on goals.
Usually, young individuals should be able to take more risks than older individuals. Young individuals have the capability to make more money working and have more time on their hands to handle market fluctuations.
4. Portfolio size
The larger the portfolio, the more tolerant to risk. An investor with a $50 million portfolio will be able to take more risk than an investor with a $5 million portfolio. If value drop, the percentage loss is much less in a larger portfolio when compared to a smaller portfolio.
5. Investor comfort level
Each investor handles risk differently. Some investors are naturally more comfortable with taking risks than others. On the contrary, market volatility can be extremely stressful for some investors. Risk tolerance is, therefore, directly related to how comfortable an investor is while taking risks.
Types of Risk Tolerance
Investors are usually classified into three main categories based on how much risk they can tolerate. The categories are based on many factors, few of which have been discussed above. The three categories are:
Aggressive risk investors are well versed with the market and take huge risks. Such types of investors are used to seeing large upward and downward movements in their portfolio. Aggressive investors are known to be wealthy, experienced, and usually have a broad portfolio.
They prefer asset classes with a dynamic price movement, such as equities. Due to the amount of risk they take, they reap superior returns when the market is doing well and naturally face huge losses when the market performs poorly. However, they do not panic sell at times of crisis in the market as they are used to fluctuations on a daily basis.
Moderate risk investors are relatively less risk-tolerant when compared to aggressive risk investors. They take on some risk and usually set a percentage of losses they can handle. They balance their investments between risky and safe asset classes. With the moderate approach, they earn lesser than aggressive investors when the market does well but does not suffer huge losses when the market falls.
Conservative investors take the least risk in the market. They do not indulge in risky investments at all and go for the options they feel are safest. They prioritize avoiding losses above making gains. The asset classes they invest in are limited to a few, such as FD and PPF, where their capital is protected.
Ignoring Risk Tolerance
Investing without considering risk tolerance can prove to be fatal. An investor must know how to react when the value of investments falls. Many investors flee the market and sell low in the process. At the same time, a market decline can be a great time to buy. Therefore, ascertaining risk tolerance helps in making informed decisions and not make hasty, wrongful decisions.
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