What Is Risk Tolerance?
Risk tolerance is the degree of risk that an investor is willing to endure given the volatility in the value of an investment. An important component in investing, risk tolerance often determines the type and amount of investments that an individual chooses.
Greater risk tolerance is often synonymous with investment in stocks, equity funds, and exchange-traded funds (ETFs), while lower risk tolerance is often associated with the purchase of bonds, bond funds, and income funds.
- Risk tolerance is a measure of the degree of loss an investor is willing to endure within their portfolio.
- Stock volatility, market swings, economic or political events, and regulatory, or interest rate changes affect an investor's tolerance for risk.
- Age, investment goals, and income contribute to an investor's risk tolerance.
- An aggressive investor commonly has a higher risk tolerance and is willing to risk more money for the possibility of better, yet unknown, returns.
- A conservative investor commonly has a lower risk tolerance and seeks investments with guaranteed returns.
Understanding Risk Tolerance
All investments involve some degree of risk and knowing their risk tolerance level helps investors plan their entire portfolio, determining how they invest. Based on how much risk they can tolerate, investors are classified as aggressive, moderate, and conservative.
Risk tolerance assessments are available online, including risk-related surveys or questionnaires. An investor may also want to review historical returns for different asset classes to determine the volatility of the various financial instruments.
One factor that affects risk tolerance includes the time horizon for an investor. Having a financial goal with a long time horizon, an investor may have greater returns by carefully investing in higher-risk assets, such as stocks. Conversely, lower-risk cash investments may be appropriate for short-term financial goals.
An investor's future earning capacity, and the presence of other assets such as a home, pension, Social Security, or an inheritance affect risk tolerance. An investor can take greater risk with investable assets when they have other, more stable sources of funds available. Additionally, investors with a larger portfolio may be more tolerant to risk, as the percentage of loss is much less in a larger portfolio when compared to a smaller portfolio.
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Aggressive Risk Tolerance
An aggressive investor, or one with a high-risk tolerance, is willing to risk losing money to get potentially better results. Aggressive investors tend to be market-savvy with an understanding of the volatility of securities and follow strategies for achieving higher than average returns.
Their investments emphasize capital appreciation rather than income or preserving their principal investment. This investor's asset allocation commonly includes stocks and little or no allocation to bonds or cash.
Moderate Risk Tolerance
Moderate investors want to grow their money without losing too much. Their goal is to weigh opportunities and risks and this investor's approach is sometimes described as a “balanced” strategy.
Commonly, moderate investors develop a portfolio that includes a mixture of stocks and bonds, perhaps as a 50/50 or 60/40 structure.
Conservative Risk Tolerance
Conservative investors are willing to accept little to no volatility in their investment portfolios. Retirees or those close to retirement age are often included in this category as they may be unwilling to risk a loss to their principal investment and have a short-term investment strategy.
A conservative investor targets vehicles that are guaranteed and highly liquid. Risk-averse individuals commonly opt for bank certificates of deposit (CDs), money markets, or U.S. Treasuries for income and preservation of capital.
What Is an Example of a 60/40 Portfolio Structure?
A moderate risk-tolerant investor may choose to invest in a 60/40 structure which may include a 60% investment in stocks, 30% in bonds, and 10% in cash.
What Financial Instruments are Considered High Risk Investments?
High-risk investments include investing in options, initial public offerings (IPO), and foreign emerging markets.
How Does Risk Tolerance Compare to Risk Capacity?
While risk tolerance measures an investor's willingness to take risk, an investor's risk capacity measures their financial ability to take a risk.