Risk tolerance definition
Stocks, bonds, ETFs, or mutual funds – all kinds of investments have corresponding risks. Risk and reward are 2 terms that never go apart in investment. How you manage the 2 is the key to becoming a successful investor.
In investing, risk tolerance is defined as the amount of risk an investor is willing to withstand. It is very important to gauge which risk tolerance level you can take in order to assess the kinds of investments and the trading style you should adapt.
However, gauging the risk tolerance is a little tricky. There are a lot of quizzes and questionnaires you can take online, but these are not at all foolproof. The most important part of calculating your risk tolerance is your understanding of yourself.
2 Aspects of risk tolerance
Capacity for risk – a more simplified view on this is how much can you afford to lose? It is made from a purely financial point of view. An investor may depend the answer on his/her salary, expenses, needs, and the where the money for the investment is taken from.
Reaction to risk – this is observed when losses are incurred in the market. It shows the emotional standpoint of the investor. It differs from each person psychologically. Some may bail out at the sight of losses, while others could observe for a while before making any necessary actions.
Factors to assess your risk tolerance
Investment horizon – this refers to the length of time the investor plans to stay invested in a particular security. Generally, investors with a longer time horizon can afford to invest aggressively or have a high risk tolerance. This is because long term investors have more time to ride out short term market fluctuations. Another reason is because riskier investments usually make bigger returns over time, which is the main reason for investors to go long. Short term investors, on the other hand, usually need to secure safer investments so as to avoid high loss risk at any time they need to pull out their money.
Investment goals – similar to the investment horizon, high risk tolerant investors usually wish to generate higher capital gains than low risk tolerant ones. Those who are only looking to make money from smaller price movements in the market should consider going for safer investments.
Investment capital – investors who have great amounts of capital lying around for investments can go for higher risk profiles while those who invest a part of their monthly income and often depends their expenses on their investments are more inclined to lower risk profiles.
Psychological factors – usually, simply observing the behavior of investors regarding their investments can give a hint on their risk tolerance. Investors who always check their gains and losses a few times throughout the day often have low risk tolerance. These are the same people who can’t withstand watching their investments fall from the daily market volatility. On the other hand, those who let their investments sit for a few weeks to a few months usually have higher risk tolerance. They do not let temporary losses affect them. Instead, they simply let their investments grow by themselves.
Risk tolerance quiz and questionnaires – as mentioned before, there are many quizzes and questionnaires available online for anyone to take. Financial advisers also provide their own questionnaires to gauge their client’s risk tolerance before they start managing their investments. These may be helpful, but investors are encouraged to take several tests every now and then since risk tolerance is more on the psychological part of the person, thus it may change and be influenced by different factors from time to time.
Risk tolerance levels
High risk tolerance / aggressive investor – you are the kind of investor who has the capacity to handle extreme levels of volatility. You can handle the possibility of massive losses but you don’t let this affect you too much. You enjoy sitting back during downfalls and patiently wait for times of recovery.
Average risk tolerance / moderate investor – you have the capacity to handle average-sized falls on your investments for extended periods although these drops make you a little anxious and you may end up securing your investments through setting stop losses in periods of market volatility.
Low risk tolerance / conservative investor – you are the type who can’t handle losses below 5 percent of your investments. You usually find yourself pulling back an investment every time this occurs. The safest investments for you are mostly bonds and bank accounts.
A good strategy to adapt whichever risk tolerance level you have is to divide your investments into baskets, with each basket filled with a separate goal. For example, have a basket of investments created strictly for capital growth, which can be invested more aggressively than one which is created as an emergency fund.
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