What Is Risk Tolerance?
Risk tolerance is the degree of risk that an investor is willing to endure given the volatility in the value of an investment. An important component in investing, risk tolerance often determines the type and amount of investments that an individual chooses.
Greater risk tolerance is often synonymous with investment in stocks, equity funds, and exchange-traded funds (ETFs), while lower risk tolerance is often associated with the purchase of bonds, bond funds, and income funds.
Key Takeaways
- Risk tolerance is a measure of the degree of loss an investor is willing to endure within their portfolio.
- Stock volatility, market swings, economic or political events, and regulatory, or interest rate changes affect an investor's tolerance for risk.
- Age, investment goals, and income contribute to an investor's risk tolerance.
- An aggressive investor commonly has a higher risk tolerance and is willing to risk more money for the possibility of better, yet unknown, returns.
- A conservative investor commonly has a lower risk tolerance and seeks investments with guaranteed returns.
Understanding Risk Tolerance
All investments involve some degree of risk and knowing their risk tolerance level helps investors plan their entire portfolio, determining how they invest. Based on how much risk they can tolerate, investors are classified as aggressive, moderate, and conservative.
Risk tolerance assessmentsare available online, includingrisk-related surveys or questionnaires. An investor may also want to review historical returns for different asset classes to determine the volatility of the various financial instruments.
One factor that affects risk tolerance includes the time horizon for an investor. Having a financial goal with a long time horizon, an investor may have greater returns by carefully investing in higher-risk assets, such as stocks. Conversely, lower-risk cash investments may be appropriate for short-term financial goals.
An investor's future earning capacity, and the presence of other assets such as a home, pension, Social Security, or an inheritance affect risk tolerance. An investor can take greater risk with investable assets when they have other, more stable sources of funds available. Additionally, investors with a larger portfolio may be more tolerant to risk, as the percentage of loss is much less in a larger portfolio when compared to a smaller portfolio.
Aggressive Risk Tolerance
An aggressive investor, or one with a high-risk tolerance, is willing to risk losing money to get potentially better results. Aggressive investors tend to be market-savvy with an understanding of the volatility of securities and follow strategies for achieving higher than average returns.
Their investments emphasizecapital appreciationrather than income or preserving their principal investment. This investor's asset allocation commonly includes stocks and little or no allocation to bonds or cash.
Moderate Risk Tolerance
Moderate investors want to grow their money without losing too much. Their goal is to weigh opportunities and risks and this investor's approach is sometimes described as a “balanced” strategy.
Commonly, moderate investors develop a portfolio that includes a mixture of stocks and bonds, perhaps as a 50/50 or 60/40 structure.
Conservative Risk Tolerance
Conservative investors are willing to accept little to no volatility in their investment portfolios. 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 and have a short-term investment strategy.
A conservative investor targets vehicles that are guaranteed and highly liquid. Risk-averse individuals commonly opt for bank certificates of deposit (CDs), money markets, or U.S. Treasuries for income and preservation of capital.
What Is an Example of a 60/40 Portfolio Structure?
A moderate risk-tolerant investor may choose to invest in a 60/40 structure which may include a 60% investment in stocks, 30% in bonds, and 10% in cash.
What Financial Instruments are Considered High Risk Investments?
How Does Risk Tolerance Compare to Risk Capacity?
While risk tolerance measures an investor's willingness to take risk, an investor's risk capacity measures their financial ability to take a risk.
FAQs
It can also be described as their emotional limit, or their willingness to take on a certain level of risk. Risk tolerance is one of the most important components of any investment strategy because it determines the mix of stocks, bonds and cash in the investor's portfolio.
What is risk tolerance and why does it matter? ›
Simply put, risk tolerance is the level of risk an investor is willing to take. But being able to accurately gauge your appetite for risk can be tricky. Risk can mean opportunity, excitement or a shot at big gains—a "you have to be in it to win it" mindset.
Why is it important for you to understand your risk tolerance before you start investing responses? ›
Investments with the potential for higher returns often come with a higher potential for sudden downdrafts or outright loss. With an understanding of your risk tolerance, you can create a strategy for your investments that will help you balance the worries of volatility with the potential for bigger returns.
What is the function of risk tolerance? ›
Risk tolerance - The levels of risk taking acceptable to achieve a specific objective or manage a category of risk. Risk tolerance represents the practical application of risk appetite and is typically aligned to categories of risk such as strategy, financial, people or reputation.
How do you interpret risk tolerance? ›
It should be defined as liquid capital or capital that can easily be converted into cash. Therefore, an investor or trader with a high net worth can assume more risk. The smaller the percentage of your overall net worth the investment or trade makes up, the more aggressive the risk tolerance can be.
What is tolerance Why is it important? ›
Tolerance is the ability for someone to endure someone's belief that they may not agree with. Tolerance is important because it promotes a more cohesive, happy society.
What does risk tolerance mean in safety? ›
What is risk tolerance? Risk tolerance is defined as the willingness of a worker or a group to take safety risks. It involves evaluating multiple factors that influence a decision to either accept or reduce risk. Generally, we might have an acceptance of a risk that is too high.
How do you deal with risk tolerance? ›
6 Ways to Increase Your Risk Tolerance
- Emergency Fund and Short-Term Savings. ...
- Income Diversification. ...
- Understand Investment History, Theory, and Expected Performance. ...
- Understand All the Risks You Face. ...
- Develop Entrepreneurial Skills. ...
- A Change in Attitude.
Why is it important for you to understand YOUR risk tolerance before you start investing? You should tailor your investment portfolio so that it assumes an amount of risk you are comfortable with.
Why is it important to understand risk and return? ›
The relationship between investment risk and return is a fundamental investment principle. If an investor desires to achieve higher investment returns, they must be willing to accept greater investment risk.
Value-at-Risk is a common example of this class. Risk tolerance is the level of risk that an investor is willing to take. But, gauging risk appetite accurately can be a tricky task.
Who is responsible for risk tolerance? ›
A company's management team, including directors and senior executives, should thoroughly understand risk appetite and risk tolerance. Company leaders are responsible for identifying and managing business risks. They should also ensure that all employees understand the company's risk-taking preferences.
Why is risk ability more important than risk tolerance? ›
Key Takeaways
Risk tolerance is about emotional & psychological comfort with risk; risk capacity is about one's financial ability to bear it. Both factors are crucial for crafting a balanced, effective investment strategy. Risk tolerance is fluid and can change due to life events, age, and economic conditions.
Why does risk tolerance matter? ›
Risk tolerance, is an important measure in financial planning that reflects how much a client is willing to endure in potential financial losses. It can establish the level and type of investment risk that a client can handle, making it an essential component when crafting a suitable investment strategy.
What is risk tolerance with example? ›
For example, an individual who is willing to forego high returns to make sure their investments stay safe are individuals with low-risk tolerance. On the other hand, if an investor opts for higher returns at the cost of the safety of the invested amount, then he/she has a high-risk tolerance.
What is the risk tolerance rule? ›
“Generally, the higher the risk, the greater your rewards — or losses — could be.” That brings us to risk tolerance, officially defined by the U.S. Securities and Exchange Commission (SEC) as “an investor's ability and willingness to lose some or all of an investment in exchange for greater potential returns.”
Why is risk tolerance important in project management? ›
A high risk tolerance may lead to accepting or exploiting more risks, whereas a low risk tolerance could focus on mitigating or avoiding risks. Project managers must navigate these uncertainties by seeking to align the attitudes of key stakeholders.
What is the risk tolerance theory? ›
Risk tolerance refers to the ability to withstand volatility or fluctuations in returns (Grable & Lytton, 1999; Shah, Khalid, Khan, Arif, & Khan, 2020). However, FRT refers to the minimum amount of uncertainty a person is willing and able to accept in making a financial decision (Grable, 2000; Nguyen et al., 2019).
What is acceptable risk tolerance? ›
A risk tolerance range for minimum and maximum levels of risk is usually set by the committee that oversees the organization's risk management strategy, and is then approved by leadership. High risk tolerance means that an organization is willing to take lots of risk, while low risk tolerance means the company isn't.
