What is Risk Tolerance and Why It’s Important
Before beginning to build an investment portfolio, you should consider the investment strategy you intend to adopt when purchasing assets – and risk tolerance is one of the most crucial factors to take into account.
Having a knock-on effect on the type of assets you should choose to invest in to build up your portfolio – and the respective allocations of your investment budget to each of these asset classes – knowing what your risk tolerance is will help you to build the portfolio most suited to you.
What is risk tolerance?
An investor’s risk tolerance is their ability to endure risk when investing – essentially, the amount of potential loss they are willing to endure from the investments made in their portfolio.
There are three main types of risk tolerance:
Conservative risk tolerance.
Investors want to take as little risk as possible when they have a conservative risk tolerance; they’re willing to enjoy smaller returns from their investment portfolio in exchange for minimized risk, with a focus on preserving their investments.
Those with a conservative risk tolerance invest in assets such as money markets, bank certificates of deposit and lower-risk bonds.
Moderate risk tolerance.
Lying between low and high-risk tolerance, moderate risk tolerance investment portfolios contain a mixture of low-risk and high-risk asset types.
Investors with a moderate risk tolerance will usually use either the 50/50 method or the 60/40 method – a.k.a. allocating 60% of their investment budget to higher risk assets such as stocks and 40% to lower risk assets classes.
Aggressive risk tolerance.
Investors with aggressive risk tolerance are willing to sustain the risk of great potential losses in order to open up the possibility of achieving huge rewards.
The portfolio of an investor with an aggressive risk tolerance will be comprised mainly – or completely – of high-risk assets such as stocks, which are more likely to reap greater rewards over time but are also subject to large downswings in value.
How do you know your risk tolerance?
There are several factors that are likely to influence an individual’s risk tolerance.
For example, older investors nearing – or already enjoying – their retirement are more likely to have a conservative risk tolerance as, typically, high-risk assets are best invested in over a long period of time.
In contrast, a younger person – with the advantage of the rest of their lives ahead of them – is more likely to enjoy the benefits of long-term growth that high-risk stocks can present.
Moreover, a person with a lot of wealth, plenty of disposable income or an array of other stable income sources may have a higher risk tolerance as the prospect of loss on high-risk assets won’t really put a dent in their financial situation, regardless of age.
Or, if someone is saving for a short-term financial goal – such as affording the deposit on a house within a year or two – their risk tolerance should be low since they’ll want to grow (but more importantly, conserve) the money they have to achieve that goal, rather than subject it to great risk.
However, the biggest deciding factor of an investor’s risk tolerance is an investor’s own sensibilities.
If an investor has a portfolio comprised of high-risk stocks, they need to be able to cope well with dips in the market and drastic changes in the value of their investments, especially when that value dips downwards.
If these things will cause immense stress and anxiety – and may potentially cause an investor to panic-sell their assets when the market is falling – they’d be better off building a portfolio that lends itself to conservative or moderate risk tolerance.
Why is it important to know your risk tolerance?
Knowing your risk tolerance is crucial to ensuring you get the most out of your investments.
For example, if you were to build an investment portfolio comprised of high-risk stocks – without taking into account your own risk tolerance – then you may panic-sell your assets when the market is falling, when they may have increased in value over the long term, causing you to lose money where you might have made it.
Moreover, if you have specific, shorter-term financial goals that you need to meet – and have limited disposable income in order to meet those goals – then investing in a ton of high-risk stocks exposes you to risk that is unlikely to be worth the rewards in the short-term and may prevent you from meeting those financial goals.
On the other hand, if you’re focused on long-term growth, and have enough disposable income to maintain your financial stability while investing – and you’re not overly stressed about potential declines in the value of your investments – then building a portfolio comprised of investments with conservative risk may be a waste of the potential rewards that await you if you embrace your high-risk tolerance.