What is risk tolerance?
All investments involve a degree of risk: there's always a possibility of loss as well as profit. Before you invest, you need to understand how much risk you are comfortable with. This is known as your risk tolerance.
A clear and simple risk tolerance definition is “a certain degree of variability in investment returns that a trader feels acceptable to withstand.”
Defining your risk tolerance is one of the major steps before choosing investment prospects most aligned with your financial goals. Risk tolerance usually relates to an asset’s volatility, market price swings, and the amount of market risk.
Where have you heard about risk tolerance?
Financial advisers will assess your risk tolerance before recommending investments. There are also online questionnaires that do this.
What you need to know about risk tolerance...
Your risk tolerance will be affected by your financial situation and your investment goals, as well as your planning horizon.
If you are investing for the long-term, you might be willing to accept more risk than you would if you were approaching retirement. But it's also a matter of what you personally feel at ease with.
You should have a realistic understanding of your ability and willingness to absorb large swings in the value of your investments. If you take on too much risk, you may panic and sell at the wrong time.
There are several major types of risk tolerance, including aggressive, moderate and conservative risk tolerance.
Aggressive risk tolerance
Aggressive investors usually have deep knowledge of stock markets. Their experience and understanding of the markets’ behaviour allow them to invest in highly volatile financial instruments. Aggressive investors prefer to take up the maximum risk in order to reach maximum returns.
Moderate risk tolerance
Investors with moderate risk tolerance prefer a well-balanced approach. They combine highly volatile stocks with less volatile bonds and try to maintain an even ratio of risky and safer investments in their portfolio structure.
Conservative risk tolerance
Investors who are only willing to compose their portfolio of assets with little to no volatility choose a conservative approach. They concentrate on instruments that are highly liquid and guaranteed. Conservative investors are also called risk-averse.
Although there are numerous risk tolerance questionnaires, analysing your reaction to a certain market scenario, it is much more challenging to predict and control your trading behaviour in advance. A realistic assessment of your own preferences may help you avoid crucial mistakes.
Risk tolerance encompasses another feature called risk capacity, which means the amount of risk a trader can afford, rather than the risk they are willing to take.
It means that you may feel comfortable with a high-risk, or aggressive, portfolio. However, if you only have several years before retirement, you may simply have no time to reach your ambitious investment goals, making it a mistake to hold a portfolio comprised of only volatile stocks. In this case, a moderate, lower-risk, or conservative portfolio would be more feasible.