Risk tolerance is the degree of risk an investor is willing to take and is determined by six main factors. Find out how to determine this critical metric.
In the world of investing, it is critical to understand and stay within the constraints of specified risk tolerance. All investments carry some level of risk. And there is never a guarantee of positive returns.
Investors exposed to volatility they are not comfortable with can lead to the premature selling of blue chip long-term stocks. Similarly, sticking to low-risk, low-return asset classes can provide mediocre results. So, let’s take a look at the factors that affect an investor’s personal risk tolerance level and the role this metric plays in managing portfolio risk.
What is risk tolerance?
Each investment is exposed to a different degree of risk. And an investor’s risk tolerance is how much risk he is willing and able to take to achieve his investment objectives.
People looking to build wealth may be more comfortable with risk and have the stomach to invest in more volatile asset classes. Others may be more interested in preserving wealth, focusing more on “safer” opportunities within the stock market and beyond.
The compromise of the risk tolerance level of two main components:
- Risk Capacity – This is the amount of risk an investor can take based on their financial position and other personal factors, such as age, time horizon and investment objectives.
- risk appetite – This is the risk that an investor is willing to take. Appetite is not based directly on any tangible metric, but on how an investor feels. A naturally more conservative person will have a lower risk appetite, and vice versa.
Sometimes an investor may have an appetite that is less than his or her risk capacity. In other words, they may make riskier investments but feel uncomfortable doing so.
In this scenario, an investment advisor will try to educate the investor about this possibility and convince them to explore higher risk, higher return opportunities. But at the end of the day, if the investor is still uncomfortable with the idea, risk tolerance equals risk appetite.
The opposite is also possible. An investor may have an appetite for risk that exceeds his capacity. This means that they are willing to make risky investments even if they do not have the financial strength to support these transactions.
In this situation, an investment advisor will educate and try to convince the investor to change his investment strategy to be more conservative. Here, risk tolerance equals risk capacity.
6 Factors That Affect Risk Tolerance
There is no specific formula to determine risk appetite or risk capacity. Therefore, assessing an individual’s risk tolerance level can sometimes be challenging. However, six main factors can influence these metrics and provide a rough estimate of these limits.
- investment objectives – Investors should determine their goals before beginning an investment journey. Generally speaking, the riskier asset classes can support long-term goals, such as building a retirement fund. After all, there is more time available to undo any unfortunate loss. However, short-term goals, such as saving to buy a car in the next two years, often require a more conservative approach, since there is a greater risk of not having the capital available when needed.
- time horizon – This is partially linked to the investment objectives. Investors with a longer time horizon have a high capacity to take risks. For example, an investor saving for retirement who still has 20 years of work left can generally take on more risk than someone who has only five years to go before receiving his or her pension.
- Age – Young investors may be willing to take on riskier investments due to the ability to easily withstand market pressures on their portfolio. They have time and opportunity to recover where there is a failed investment. This is not so with older investors looking for relatively safe investments.
- wallet size – The total value of an investment portfolio can influence investors’ risk tolerance. An investor with a large portfolio may be willing to make riskier investments. Because? Because even after substantial losses, a large sum of capital will remain.
- risk appetite – As mentioned above, even if an investor may take additional risk, they may choose not to if they feel uncomfortable exposing their portfolio to increased market volatility.
What are the three categories of risk tolerance?
Investment advisors and financial planners will meet regularly with clients to determine or update their risk tolerance. After all, this metric is constantly changing. A person who suddenly suffers from a health problem may retire earlier than expected, requiring a more conservative investment approach. Or maybe they are lucky enough to win the national lottery and have the ability to take more aggressive positions.
As part of this discussion, the professional can place their clients into one of three categories:
- Aggressive – These are investors with a higher risk tolerance who are comfortable taking substantial risks to achieve their objectives. They may be more interested in small-cap and penny stocks or want to explore stock options and other financial derivatives to try and maximize returns. These portfolios can perform admirably during a bull market. But the losses could be just as severe when a bear market finally appears.
- Moderate – These investors are often looking to balance the ratio between risky and “safe” asset classes in their portfolio. The most common example would be a 60/40 split between stocks and bonds. They can still benefit from strong returns during a bull market. But if the winds were to change, the level of negative impact on your portfolio would likely be less damaging compared to an aggressive investor.
- Conservative – These investors usually have a very low tolerance for risk. And in some cases, they may stick exclusively to asset classes that fail to even beat inflation, simply out of fear of market volatility. In most cases, overly conservative investors will rarely enjoy significant returns. However, if the stock market or economy takes a turn for the worse, these types of defensive portfolios are often the most resilient and protect wealth.
What happens if investors ignore the risk?
Investing is inherently risky. And investors who do not correctly consider their risk exposure to specific threats can end up in a world of financial ruin. While that may seem obvious on paper, it can be a difficult mantra to follow in practice. This is especially true when other investors seem to be prospering off of a new “hot” asset class.
Before committing to any investment decision, the asset must be evaluated in relation to an investor’s risk tolerance. If it exceeds the limits, it should not be added to an investment portfolio regardless of return potential.
The bottom line
Factors such as volatility, price fluctuations, inflation, and other economic circumstances can adversely affect an investment. And investors must fully understand the likely risk their investment is exposed to in order to properly execute a risk management strategy.
Not only does this help you make more informed decisions, but it can also prevent a once-prosperous portfolio from taking a nosedive. That’s why investors should spend time determining their risk tolerance and then rigorously adhere to it throughout their investment journey.
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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment depends on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor should consider his or her individual financial circumstances and contact an independent financial adviser if necessary.
Edited and verified by
Master of Science Zaven Boyrazian
Zaven has worked in various industries throughout his career, from aircraft factories to game development studios. He has been actively investing in the stock market for the better part of a decade, managing over $1 million across multiple portfolios.
Specializing in corporate valuation, Zaven employs a modern version of the principles established by Benjamin Graham to find new opportunities at fair prices.
