What is Risk Tolerance?

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  • 06 Nov 2023
What is Risk Tolerance?

Key Highlights:

  • Risk Tolerance is important for taking wise investment decisions

  • Investors with higher disposable income usually have greater risk tolerance, as they have the financial flexibility to accommodate market volatility.

  • Conservative choices indicate low risk tolerance, while willingness to take risks and hold investments demonstrates higher risk tolerance.

Financial planners categorise individuals according to their risk tolerance and use this information to tailor portfolios to their risk profiles. Having a true understanding of one's risk tolerance, considering objective and subjective factors, is essential to making informed investment choices. This understanding is very important for wise investment decisions. For example, someone with low risk tolerance may be prepared to forgo high returns to ensure the safety of their investments. On the other hand investors have a high risk tolerance if they choose to give up the safety of their investments in exchange for better returns.

Factors Influencing Risk Tolerance

Factors influencing risk tolerance are crucial considerations for investors, shaping their ability to handle market fluctuations and make sound investment decisions.Here are some key factors that influence risk tolerance:

1. The Age

Age is one of the main factors that determines a person's risk tolerance. A person's risk tolerance is usually higher when they are younger. This is a result of having more time and resources to heal from the setbacks.

On the other hand, a person who is getting close to retirement age is unlikely to have a high risk tolerance. mostly because one does not have the guarantee of time or the financial means to offset the short-term market volatility if they are retired or close to retirement.

2. Economic Situation

The financial situation of an investor is arguably the most important factor influencing risk tolerance. A large asset allocation and low ratio of liabilities indicates that an investor is probably willing to take on more risk. A person with a large amount of liabilities in comparison to assets, on the other hand, can have a poor risk tolerance. And that's because of the previously stated opposing factor. A person with precarious finances lacks the margin to absorb losses and ride out market fluctuations.

3. Disposable Income

Undoubtedly, one of the main factors influencing someone's risk tolerance is their disposable income. A high-income investor is usually a high-risk investor, and vice versa. It is due to the same factor of ample financial flexibility to accommodate volatility. For an appropriate assessment of risk tolerance, people must consider not only their disposable income but also their potential for future income and earning potential.

4. Time Horizon

The duration for which an investor can comfortably defer the return of their investment plays a pivotal role in evaluating their risk tolerance. A long-term investor typically has a high tolerance for risk. This is due to the fact that while market fluctuations are significant in the short term, they have little effect on returns over the long term, roughly seven to ten years.

Investors with short time horizons have poor risk tolerance for the same reason. In the short term, they would also be taking a significant amount of risk if they chose high-return investments like stocks.

Here's a breakdown of the different types of risk tolerance, each representing a unique approach to managing investments.

1. Conservative

This group of risk-tolerant investors includes conservatives who value financial security over wealth growth. Debt instruments and debt-based mutual funds make up the majority of these investors' portfolios. a tendency to sell stocks as soon as prices begin to decline is an example of low-risk tolerance.

2. Moderate

Moderate Risk-takers are people who like wealth creation but are willing to take on moderate amounts of risk. There are the most variants in this category due to the large range of risk tolerance levels. Typically, these investors have a medium-sized time horizon. Patiently awaiting out market fluctuations instead of selling shares right away is an example of a moderate risk tolerance.

3. Aggressive

With aggressive investment techniques, investors in this category prioritise wealth appreciation over losses or market volatility. They are usually shrewd investors who have extensive understanding of market-linked instruments and aren't afraid to take calculated risks with their money. Since their goals are long-term focused, doing nothing amid short-term market volatility would be an example of a high-risk tolerance.

Financial organisations use other methods to assess a person's risk tolerance. An important tool is a questionnaire. These surveys are designed in such a way as to understand a person's subjective playfield in response to different situations. One possible question may be, "What would you do if the values of the stocks you own fell?

A. Make the sale B. Hold on C. Buy new stock

Choosing choice A in this situation demonstrates conservatism and a low threshold for risk. Option C exhibits a high degree of risk tolerance as well as foresight in anticipating future price increases, which will enable them to sell their investment for a profit. Furthermore, Option B represents a typical moderate risk-taker. These tests are not infallible, though as someone may select option C on paper but sell equities in real life if they experience fear.

Conclusion

Assessing one's risk tolerance is essential before beginning any financial planning in order to determine which assets can boost one's portfolio. Risk tolerance varies with time, thus it's important to periodically reevaluate and update yourself. You're one step closer to reaching your financial objectives when you can precisely determine your investment risk tolerance and then make investments in a portfolio that take into account your time horizon, personal circumstances.

FAQs on What is Risk Tolerance

Yes, financial advisors are trained to assess risk tolerance and can guide you in making investment decisions that align with your comfort level.

If your risk tolerance is low, it's advisable to choose conservative investments to minimise the potential for significant losses.

Economic factors such as inflation and economic stability can impact risk tolerance, prompting investors to adjust their strategies based on the prevailing economic conditions.

Investing beyond your risk tolerance can lead to emotional distress and impulsive decision-making, potentially harming your financial well-being.

Yes, it's advisable to reassess your risk tolerance periodically, especially when significant life changes occur, to ensure your investments are still aligned with your comfort level.

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