Risk tolerance is an investor’s ability to withstand volatility and fluctuating returns on its portfolio. Risk tolerance is among the most important concepts to consider before investing in the stock market. Investors should build their portfolios based on their risk profile.
It is also intrinsically related to risk appetite. Determining both before investing is a key part of building any investment portfolio. It ensures that you will not panic and sell your investments if they decline significantly in price.
Investors that cannot deal with volatility, and see their holdings decrease in price significantly, should consider investing in index funds.
Factors that influence risk tolerance
There are several factors that can influence your risk tolerance. All of us are different to a certain extent, and our behavior while investing is also different. Some investors are more emotional and tend to panic if they see their holdings decrease in price significantly. Investing is not rocket science, but it requires a special personality to see your portfolio lose a big percentage of its value without reacting emotionally.
Age can also influence an investor's risk tolerance. As we get older, it is wise to steer away from risky investments and focus on capital preservation.
Risk tolerance is also dependent on the financial goals you have. To be able to achieve a certain level of success, and to accumulate significant wealth, you have to be able to take risks. Failing to do so might mean that you will not be able to fully achieve your goals.
Your investment horizon is another key factor to determine your risk tolerance. You might be able to take increasingly more risks if your investment horizon is longer. On the other hand, if your investment horizon is short, you might avoid risky investments.
Types of risk tolerance
Broadly speaking there are three types of risk profiles:
Individuals who are well acquainted with the financial markets, and know their ins and outs are usually high-risk tolerant. This allows them to invest in high-risk securities that are often overlooked by most common investors. The fact that you have a high-risk tolerance does not mean, you only invest in high-risk investments. Investors with high-risk tolerance might trade derivatives and speculative securities like small caps. The main goal is capital appreciation at all costs.
Investors with a moderate risk tolerance will often have some risky investments, but they diversify. So a portfolio for moderate risk-tolerant investors will have a risk component and more safe stocks. These investors seek capital appreciation with some safety.
Investors that are focused on capital preservation tend to avoid risks. Their conservative approach allows them to achieve smaller returns, but with fewer risks. This risk tolerance profile is also associated with retirees that tend to steer away from any risks.
How to define your risk tolerance?
There are a few ways to define your risk tolerance. Perhaps the most important step is to determine what your investment horizon is, and what are your investment goals. This should allow you to determine what kind of investment approach suits both your goals and investment horizon the best.
Another important aspect is to determine if you are more inclined towards capital appreciation or capital preservation. This should define how you would feel losing let's say $100 vs earning $100. This can be an easy way to assess your risk profile overall.
Investors should also consider their preferred asset class. Some asset classes tend to be riskier than others, and this can also influence your risk tolerance.
Lastly, your current financial situation should also be considered. Depending on it, you should adjust your investment strategy, and take risks based on that.
Consider these as the most important aspects to define your risk tolerance. Also try to put into perspective your current investment knowledge, your emotional response when you lose money, and your age.
Having a good understanding of your ability to deal with risk is a crucial point when you build your investment portfolio. Falling to do so, might mean that you either make high-risk investments that you cannot stomach or that you end up making low-risk investments and sacrificing your possible returns.
It is also important to mention that within a portfolio you can have some riskier holdings and low-risk holding. The key is to allocate your capital based on risk, and diversify so that you can mitigate some of the risks. Your portfolio might decline in value, due to volatility, and it is important to distinguish between that and risk. There are also ways to deal with portfolio underperformance.
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