Risk tolerance is the level of variability in investment returns that an investor is willing to tolerate in their financial planning. Risk tolerance is an important factor in investing and investors should determine how able or willing they are to tolerate large swings in the value of their investments.
Taking on too much risk can cause panic to set in and poor investment decisions being made, but too little risk could lead to missed opportunities. There is a direct correlation between the age of an investor and their risk tolerance.
Younger investors, with years of investment opportunities ahead of them are often encouraged to take on more risk as they have the horizon to build back, whereas older investors with shorter horizons are often advised to limit their risk.
It is also important to note that investors with a higher net worth and more disposable income are often likely to take greater risks with their investments.
How risk tolerance works
Investors assess and determine their risk tolerance by first understanding their investment objectives. For example, if you are investing to enhance your pension pot you may not want to assume too much risk. Particularly if you are close to retirement age.
But if you are investing disposable income with the goal of increasing your wealth via an extra income stream you may choose to assume a higher level of risk.
Risk-related surveys and questionnaires can help an investor determine their risk tolerance, but financial advice should also be sought.
Investors may also want to review historical worst-case returns for assets across a range of classes. Doing so can help them understand how comfortable they would be losing part or all of their investment if it performed badly for a long period of time.
Other factors that affect an investors tolerance to risk are the time period they would have for their investment to bounce back, future earning capacity and other assets such as a house, pension or an inheritance. Having a greater net worth or a safety net to fall back on may increase your tolerance to risk.
Types of risk tolerance
Risk tolerance can be broken down into three categories, they are:
Aggressive risk tolerance
Investors with an aggressive risk tolerance tend to be market-savvy. A deep understanding of markets and securities enables individuals and institutional investors to purchase highly volatile instruments. Aggressive risk tolerance takes the approach of maximum returns with maximum risk.
Moderate risk tolerance
Investors with a moderate risk tolerance are willing to accept some risk to their principal investment but adopt a balanced approach. Moderate investors are willing to risk some of their portfolio but not all of it.
Conservative risk tolerance
Investors with a conservative risk tolerance are willing to accept little to no risk in their investment portfolio. Retirees who have spent years building a nest egg often have conservative risk tolerance.
Advantages of risk tolerance
The advantages of risk tolerance include:
Can inform your investment strategy
Understanding your risk tolerance and identifying where you fall on the risk spectrum can help inform your overall investment strategy, as it can help you know where you are comfortable and when to buy or sell.
Avoid making hasty decisions
Thinking about the risks of investing before you begin investing can help you avoid making hasty decisions further down the road. If you already know your position on risk, you will likely know your close position, which can help avoid panic and bad investment decisions.
Disadvantages of risk tolerance
The disadvantages of risk tolerance include:
Could lose out on opportunities
If you chose a moderate or conservative approach to risk tolerance you could miss out on big return opportunities, but you could also safeguard yourself against big losses as there is no guarantee that a big return will occur when it is predicted.
Can be difficult to determine without financial advice
This is especially true for novice investors, while your gut may tell you to go for an aggressive risk tolerance approach your head will likely tell you to take a moderate risk tolerance approach. But as other factors come into play including investment goals, age and investment horizon it is always best to seek the advice of an independent financial advisor.