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What Is Risk Tolerance, and Why Is It Important For Investors?

Risk tolerance is the degree of risk an investor is willing to take and is driven by six primary factors. Discover how to determine this critical metric.

by | Last updated 23 Mar, 2023 | Risk

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In the world of investing, understanding and staying within the constraints of specified risk tolerance is critical. Every investment carries some level of risk. And there is never a guarantee of positive returns.

Investors exposing themselves to volatility they’re not comfortable with may lead to premature selling of top-notch long-term stocks. Similarly, sticking to low-risk, low-return asset classes may provide lacklustre results. So, let’s take a look at what factors affect an investor’s personal risk tolerance level and the role this metric plays in portfolio risk management.

What is risk tolerance?

Every investment is exposed to a different degree of risk. And an investor’s risk tolerance is how much risk they are willing and able to take in pursuing their investment goals.

Individuals seeking to build wealth may be more comfortable with risk and have the stomach to invest in more volatile asset classes. Others may be more interested in preserving wealth, focusing more on “safer” opportunities within the stock market and beyond.

The risk tolerance level compromise of two main components:

  • Risk Capacity – This is how much risk an investor can take based on their financial position and other personal factors such as age, time horizon, and investment goals.
  • Risk Appetite – This is how much risk an investor is willing to take. Appetite isn’t directly based on any tangible metrics but rather on how an investor feels. A naturally more conservative person will have a lower risk appetite, and vice versa.

Risk Tolerance = Min(Risk Appetite, Risk Capacity)

Sometimes an investor may have an appetite lower than their risk capacity. In other words, they can make riskier investments but are uncomfortable doing so.

In this scenario, an investment adviser will try to educate the investor about this possibility and convince them to explore higher risk, higher return opportunities. But at the end of the day, if the investor is still uncomfortable with the idea, risk tolerance equals risk appetite.

The opposite is also possible. An investor may have a risk appetite that exceeds their capacity. Meaning they are willing to make risky investments even though they don’t have the financial strength to support these transactions.

In this situation, an investment adviser will educate and try to convince the investor to change their investment strategy to be more conservative. Here, risk tolerance is equal to risk capacity.

6 factors that affect risk tolerance

There is no specific formula for determining risk appetite or risk capacity. Therefore assessing an individual’s risk tolerance level can sometimes be challenging. However, six main factors can influence these metrics and provide a rough estimate of these limits.

  • Investment Goals – Investors must determine their goals before beginning an investment journey. Generally speaking, riskier asset classes can support long-term goals such as building a retirement fund. After all, there is more time available to undo any unfortunate losses. However, short-term objectives such as saving to buy a car in the next two years often require a more conservative approach as there is a greater risk of not having the capital at hand when needed.
  • Time Horizon – This is partially tied to investment goals. Investors with a longer time horizon have a high capacity for taking risks. For example, an investor saving for retirement that still has 20 years of work can typically take on more risk than someone who is only five years away from taking their pension.
  • Age – Young investors may be willing to take on riskier investments because of the ability to easily withstand the pressures of the market on their portfolio. They have time and opportunity to bounce back where there is any failed investment. This is not so with older investors who go for relatively safe investments.
  • Portfolio Size – The total value of an investment portfolio can influence investor risk tolerance. An investor with a large portfolio may be willing to take up riskier investments. Why? Because even after any substantial losses, a large sum of capital will remain left over.
  • Risk Appetite – As previously mentioned, even if an investor can take on additional risk, they may choose not to if they are uncomfortable exposing their portfolio to increased market volatility.

What are the three categories of risk tolerance?

Investment advisers and financial planners will sit down regularly with clients to determine or update their risk tolerance. After all, this metric is constantly changing. An individual suddenly suffering from a health problem may retire sooner than expected, requiring a more conservative investing approach. Or perhaps they are lucky enough to win the national lottery and have the capacity to take on more aggressive positions.

As part of this discussion, the professional may place their clients into one of three categories:

  • Aggressive – These are higher risk tolerance investors who are comfortable taking substantial risks to pursue their objectives. They may be more interested in small-cap and penny stocks or may want to explore stock options and other financial derivatives to try and maximise returns. These portfolios may perform admirably during a bull market. But the losses could be equally severe when a bear market eventually turns up.
  • Moderate – These investors often seek to balance the ratio between risky and “safe” asset classes in their portfolio. The most common example would be a 60/40 split between stocks and bonds. They can still benefit from solid returns during a bull market. But should the winds change, the level of negative impact on their portfolio would likely be less damaging compared to an aggressive investor.
  • Conservative – These investors typically have very little risk tolerance. And in some cases, they may stick exclusively to asset classes that fail to even beat inflation, simply out of fear of market volatility. In most cases, overly conservative investors will rarely enjoy any meaningful returns. However, should the stock market or economy take a turn for the worse, these types of defensive portfolios are usually the most resilient, protecting wealth.

What happens if investors ignore risk?

Investing is inherently risky. And investors who don’t correctly consider their risk exposure to specific threats can land in a world of financial ruin. While that may seem obvious on paper, it can be a difficult mantra to live by in practice. This is especially true when other investors are seemingly thriving from a “hot” new asset class.

Before committing to any investment decision, the asset must be evaluated relative to an investor’s risk tolerance. If it exceeds the limits, it should not be added to an investment portfolio regardless of the return potential.

The bottom line

Factors such as volatility, price fluctuations, inflation, and other economic circumstances can adversely affect an investment. And investors need to fully grasp the likely risk their investment is exposed to correctly execute a risk management strategy.

This not only helps make more informed decisions but can also avoid watching a once thriving portfolio take a nosedive. That’s why investors need to spend time determining their risk tolerance and then stick to it rigorously throughout their investing journey.

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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial adviser if necessary.

Written By

Prosper Ambaka, Esq.

Prosper is a self-taught financial analyst and investor with years of experience. Inspired by Benjamin Graham, he employs a value-investing school of thought throughout his analyses. This has led to Prosper developing a wealth of knowledge in equities, foreign exchange, commodities, and global macroeconomic issues.

In 2019, he completed his Law degree and was called to the Nigerian Bar in 2021. Outside The Money Cog, Prosper encourages others to join the investment community through his lectures on financial literacy as well as investing strategies.

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Edited & Fact Checked By
Zaven Boyrazian MSc

Zaven has worked in several industries throughout his career, from aircraft factories to game development studios. He has been actively investing in the stock market for the better part of a decade, managing over $1 million across multiple portfolios.

Specializing in corporate valuation, Zaven employs a modern take on the principles set out by Benjamin Graham to find new opportunities at fair prices.

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