Risk Tolerance Definition
Risk tolerance refers to the level of risk investors are ready to endure for a given investment. Every investment involves a certain degree of risk, but not all investors can bear all levels of risks. When investors learn about the level of risk they can tolerate, investment planning becomes more accurate.
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The risk endurance levels of investors vary hugely. They plan their portfolios and accordingly invest in different instruments based on the extent of risk they can bear. For example, there is comparatively a greater risk when investors choose to invest in equity, stocks, funds, exchange-traded funds (ETFs), etc., than in bonds, income funds, etc. In short, knowing their tolerance level helps investors make more informed and wiser investment decisions.
- Risk tolerance determines the degree of risk investors can tolerate before deciding to exit the market.
- It usually depends on the investor’s financial situation, type, preferences, time horizon, and purpose of investments.
- Risk tolerance is observed in three forms – aggressive, moderate, and conservative.
- An investor needs to understand risk tolerance; otherwise, they may see a large movement in the value of the investment, creating panic and causing them to sell at the wrong time.
Risk Tolerance Explained
Risk tolerance for investing lets investors be wiser about where to invest. There are multiple financial instruments involving different levels of risk. However, the level of risk that the market can impose on investors or their risk endurance capability is influenced by multiple factors, including the investors’ financial situation, types, preferences, time frame, and purpose.
The amount investors can afford to lose largely depends on how much spare money they have after meeting their basic needs. This is why a wealthy investor seems to have a high-risk tolerance than a less well-off investor who cannot risk a significant amount as that might be all the savings they have.
While a seasoned and frequent investor in the market is ready to handle more risk, given their maturity level and familiarity with the market volatility, someone new might not be able to handle a large amount of downside in the portfolio.
The preference and goals of the investors are also important factors. For example, an investor’s asset classAsset ClassAssets are classified into various classes based on their type, purpose, or the basis of return or markets. Fixed assets, equity (equity investments, equity-linked savings schemes), real estate, commodities (gold, silver, bronze), cash and cash equivalents, derivatives (equity, bonds, debt), and alternative investments such as hedge funds and bitcoins are examples. that they want to invest in determines their inclination toward spending on that particular instrument or portfolio. In addition, the purpose they desire to fulfill by investing in the instruments also helps them decide the level of risk they are ready to deal with.
Last but not least, the time frame plays a vital role. Equity investors with longer time horizons are more risk-tolerant since equities deliver superior returns over longer periods. On the contrary, a debt investor has to deal with both interest rate and reinvestment risk as the span increases.
What is risk tolerance is better answered when investors are aware of the types of it, i.e., aggressive, moderate, and conservative.
Aggressive risk investors are the ones that are well-versed in the market. They can take on large amounts of risk and bear large downward movements in their portfolio. Their characteristics usually include wealth, long time horizons, and experience in the market. Aggressive risk tolerance investors usually go for riskier asset classes, such as equities, and reap superior returns when the market performs well. In addition, they are immune to panic selling in times of market crisis.
Moderate-risk investors are relatively less risk-tolerant. They can take on some risk and usually have a set percentage of up to extent they can bear the losses. They invest some money in riskier assets such as equities and the remaining in safer assets such as debt or gold. These investors usually go for a 50-50 asset allocationAsset AllocationAsset Allocation is the process of investing your money in various asset classes such as debt, equity, mutual funds, and real estate, depending on your return expectations and risk tolerance. This makes it easier to achieve your long-term financial goals. between risky and safe assets. If the market performs well, they take home a lesser return than aggressive investors, but during downturns, their portfolio is limited to lower losses.
Conservative investors are the lowest risk-taking investors in the market who hardly take any risk and go for the safest assets they can find. They hardly bother about the lower risk yielding lower returns. Instead, they focus more on having strategies for avoiding losses than getting superior returns. Such investors usually go for assets such as bank FDs, PPFs, etc., where they think they can guarantee capital protection.
Let us consider the following risk tolerance example to understand the concept better:
Stephens invests in securities to ensure he reaps profits even if some positions do not work well. Given the income he normally generates and the risk he could bear, the investor opts to spend in three different ways. Hence, he spends 50% on stocks, 20% on bonds, 10% on ETFs, and 20% on cash equivalents.
This shows Stephens is moderate risk-tolerant.
The understanding of the risk tolerance meaning is incomplete if investors do not know its importance. Here is a list of the benefits that make it useful to investors:
- Helps plan the entire portfolio
- Enables them to make wiser investment decisions
- Helps investors withstand losses
- Enables strategizing investment steps
- Balances volatility worries
The risk endurance capability of investors helps them prepare for the worst. It also lets them know how to react when the market state deteriorates.
Risk Tolerance vs Risk Appetite
Risk tolerance and risk appetite sound similar terms, but they differ widely. Some of the differences include the following:
- The former is the level of risk investors are ready to take. On the contrary, the latter is the aggregate risk that investors are willing to accept per their risk profile.
- Risk appetite is a broad philosophical concept, whereas tolerating risk is a tactical idea.
- Risk appetite guides the risk management efforts of investors, while tolerance identifies the level of risk acceptable when making investments.
Frequently Asked Questions (FAQs)
Investors can determine their risk tolerance level based on their financial position and decide on the category of tolerance they fall under. Then, based on the financial status, they can shortlist the suitable portfolios and finally decide the percentage of investment per profile.
Conservative form is the lowest level of risk, which is fit for investors who may not be well-off enough or not ready to take many risks. Normally, low-risk investments come in the form of bond funds, bonds, income funds, etc.
The capacity is said to increase over time as investors get familiar with the market with time and begin to understand how it works. This makes them more tolerant of taking risks as they know how the market is supposed to behave at which point.
This is a guide to what is Risk Tolerance and its definition. Here, we discuss its role in investing, its types, examples, and vs risk appetite. You can learn more about accounting from the following articles –