Risk is nearly synonymous with investments, especially in stocks. However, not everyone can digest the same level of risk, and that might lead to untoward results, like selling of securities at the wrong time by panicking. Therefore, individuals should have a concrete understanding of their risk tolerance before undertaking investments of any kind.
In this article
What is Risk Tolerance?
One can define risk as the degree to which returns from a specific asset can vary. Hence, It refers to an individual’s aptitude of withstanding market volatility in general and variance in returns on their investments in specific. In other words, It refers to an individual’s willingness and capacity to suffer short-term market volatilities.
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.
Based on an individual’s risk tolerance, financial planners profile them. Financial planners utilise an investor’s risk profile to create a portfolio that complements that adequately. Therefore, it is quintessential to have a realistic comprehension of one’ risk tolerance, both at an objective and subjective level, for sound investment decisions.
What are the Factors that Influence Risk Tolerance?
One of the primary determinants of an individual’s risk tolerance is their age. If a person is of young age, typically his/her risk tolerance would be high. That’s because he/she has more time and resources to recuperate from the losses.
Conversely, a person towards retirement age will less likely have a high-risk tolerance. Mainly because, once retired or near retirement, one does not have the assurance of time or sufficient monetary resources to cushion the short-term volatilities in the market.
2. Financial standing
Perhaps the most critical of risk tolerance factors is an investor’s financial standing. An investor who has a considerable share of assets and a thin percentage of liabilities will most likely be ready to take higher risks. It’s because they have the financial capacity to wait out short-term volatilities or suffer losses.
On the other hand, an individual with a sizable set of liabilities compared to assets will possibly have a low-risk tolerance. And that’s because of the opposite reason mentioned above. An individual with a shaky financial standing does not have sufficient leeway to accommodate losses or wait out volatilities.
3. Disposable income
An individual’s disposable income is definitely a key factor that influences their risk tolerance. An investor with a high disposable income typically has a high-risk tolerance and vice versa. It’s because of the same reason mentioned in the point above, i.e. sufficient financial room to suffer volatilities.
Alongside present disposable income, individuals shall also take their future earning capacity and income promise into account for accurate risk tolerance determination.
4. Time horizon
Another critical consideration when determining an investor’s risk tolerance is the period for which they do not need the investment amount back. That time horizon is quintessential to both risk tolerance and investment objectives.
An investor with a long time horizon usually has a high-risk tolerance. That’s because market volatilities carry weight in the short-run, but in the long run, let’s say 7 – 10 years, those eventualities do not have much of a bearing on the returns.
For the same reason, investors with short-time horizons have a low-risk tolerance. If they were to choose high-return instruments, like equities, in the short-run, they’d be exposed to a high level of risk as well.
One should note that these factors are all objective fields that influence risk tolerance. However, there’s also subjectivity at play, and that might defy these set standards. For instance, an individual with a high disposable income might choose to go for low-risk instruments.
Types of Risk Tolerance
Investors who prefer corpus security more than wealth appreciation belongs to this category of risk tolerance. Such investors’ portfolios comprise debt instruments and debt-based mutual funds predominantly. A low-risk tolerance example would be the tendency to sell securities the moment prices start to dip.
Individuals who prefer wealth creation accompanied by moderate levels of risk are categorised as moderate risk-takers. This category comprises the most subtypes because of a wide range of risk tolerance levels. Such investors usually have a medium time horizon. A moderate risk tolerance example would be opting to wait out market volatilities rather than sell their securities in the first instance.
Investors in this category prioritise wealth appreciation above losses or market volatilities with aggressive investment strategies. Typically, they are market-savvies with profound knowledge of market-linked instruments that allow them to take risks with their investments. A high-risk tolerance example would be not doing anything during short-term market volatilities since their objectives are long-term oriented.
Risk Tolerance Evaluation
Apart from the factors mentioned above, financial institutions employ other means to determine an individual’s risk tolerance. One of the primary means is a questionnaire. These questionnaires are so constructed to understand an individual’s subjective playfield in response to various instances. For example, a question could go like, “What would you do if there is a fall in prices of stocks you hold?
- Sell them
- Buy new stocks.
In this case, if one goes with option A, it shows conservativeness and low-risk tolerance. One who chooses option C shows high-risk tolerance and the far-sightedness to know that prices will go up in the future when they can choose to sell it to earn higher returns. And Option B is the typical reflection of a moderate risk-taker.
However, these questionnaires are not foolproof, in the sense that an individual might choose C in paper and sell stocks in reality when confronted by panic.
Risk Appetite and Risk Tolerance
Risk appetite is a subpart of risk tolerance, which refers to an investor’s willingness to take on risk irrespective of his financial standing. It is in contrast to risk capacity, which denotes an individual’s affordability in agreeing to a degree of risk.
Both these considerations are, thus, equally critical in forming a realistic understanding of one’s risk tolerance.