Risk Tolerance Definition
Risk Tolerance is defined as the amount of risk the investor can tolerate before deciding to exit the market and usually depends on the investor’s financial situation, type, preference of asset class, time horizon, and purpose of investments. An investor needs to have an understanding of risk tolerance; otherwise, they may see a large movement in the value of investment and panic, which might cause to sell at the wrong time.
Top 5 Key Factors Affecting Risk Tolerance
Let’s discuss the Top 5 key factors that affect risk tolerance in investing.
#1 – Financial Situation
The financial situation of an investor is the first and foremost factor that affects an investor’s risk tolerance. The amount of money that the investor can afford losing is largely affected by how much money that investor has to spare after taking care of hi/her basic needs. A wealthy investor has a high-risk tolerance because the invested money is not something that he/she depends on daily needs. A less well-off investor will be able to risk less money since that might be all the savings they have.
#2 – Type of Investor
There are several types of investors in the market with varied risk profiles. For example, a seasoned and frequent investor in the market will be able to stomach more risk because he/she has seen a lot of volatility in the market and knows how the market works. On the other hand, someone new might not be able to handle a large amount of downside in the portfolio because they do not have much experience is the market.
#3 – Asset Class Preference
There are investors who have an inclination towards a particular asset class. Some might be ardent equity investors; some might prefer debt, some might be more comfortable with f&o. investors that prefer a particular asset class might be willing to tolerate a low amount of risk when they shift from their favorite asset class. This is largely seen when an investor moves from a relatively safer asset class to a relatively riskier asset class.
#4 – Time Horizon
The time horizon is a very important factor in assessing an investor’s risk tolerance. This point is also linked with asset classes as the investors in different asset classes react differently to longer or shorter time horizons. For example, equity investors with longer time horizons are more risk-tolerant since equities are known to deliver superior returns over longer periods. However, a debt investor has to deal with interest rate riskInterest Rate RiskThe risk of an asset's value changing due to interest rate volatility is known as interest rate risk. It either makes the security non-competitive or makes it more valuable. as well as re-investment risk more as the time increases. Therefore, they might prefer a shorter time horizon.
#5 – Purpose of Investment
The risk tolerance of an investor also depends on the purpose for which he/she is making that investment. It is related to a large extent to the investor’s sentiment. An investor who is saving for financial goals such as children’s education or marriage might be willing to lower risk. On the other hand, an investor investing in a foreign vacation or a new car could take a higher risk since these goals are materialistic rather than necessities.
Types of Risk Tolerance
Risk tolerance can be divided into the following types.
#1 – Aggressive
Aggressive risk investors are the ones that are well versed in the market. They are able to take on large amounts of risk and see 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. They are immune to panic selling at times of crisis in the market.
#2 – Moderate
Moderate risk investors are relatively less risk-tolerant. They are able to take on some risk and usually have a set percentage up to which they can see their portfolio in losses. They invest some of their money in riskier assets such as equities and the remaining in safer assets such as debt or gold. They usually take on 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 in the market, their portfolio suffers lower losses as well.
#3 – Conservative
Conservative investors are the lowest risk-taking investors in the market. They are hardly able to take any risk and go for the safest assets that they can find. They are not concerned with the fact that low risk would mean lower returns. They are more concerned with avoiding losses than getting superior returns. Such investors usually go for assets such as bank FDs, PPF, etc., where they think they can guarantee capital protection.
Dynamic Risk Tolerance
As we have read above, investors are classified into three broad categories based on how much risk they can take. This classification is based on a large number of factors, some of which have been listed above. Practically speaking, one or multiple factors concerning an investor could change, which might cause his/her risk tolerance to shift from one category to another. For example, a person might land a high paying job which would cause him to take a higher amount of risk. Or, someone who keeps investing in the market regularly might start understanding the workings of the market and become more confident to take higher risks. On the other hand, a huge unforeseen medical expense could cause an investor to play it safer with his/her remaining financial assetsFinancial AssetsFinancial assets are investment assets whose value derives from a contractual claim on what they represent. These are liquid assets because the economic resources or ownership can be converted into a valuable asset such as cash. and accept lower risk.
Risk Tolerance is a very important concept in the world of investing. Investors need to have a clear understanding of how much risk they can take so that they can choose their asset classes appropriately. They need to take into account all the applicable factors to arrive at that decision.
On the other hand, investment managers need to understand the investors’ risk profile as well so that they can invest their money in assets that they would be comfortable with. They need to make sure that they adhere to the investment strategy that they previously communicated to the investors.
Risk tolerance can change over time, as the factors affecting it are dynamic.
This has been a guide to what is risk tolerance and its definition. Here we discuss the top 5 key factors and classification of risk tolerance that affect investing. You can learn more about accounting from the following articles –