Understanding Risk Tolerance and the Factors Associated with it
In simple terms, Risk tolerance can be defined as the amount of risk that an individual can take with their investment opportunities. Risk tolerance is an essential factor in investing. It also refers to the degree of doubt an investor may handle about significant losses in their portfolio. While investing, you should have a better understanding of how much risk you can take. Sometimes great returns lure investors into taking the higher risk, but that can lead to significant losses.
Risk tolerance can be categorized into three categories.
Aggressive Risk Tolerance: Investors that do not have any problem with risking their money for great returns are considered aggressive investors. Aggressive investors tend to have better knowledge and understanding of the market and securities. They generally purchase highly volatile instruments, such as investing a more significant part of their portfolios in less well-established companies’ stocks. Their main aim is to maximize return by taking a higher amount of risk.
Moderate Risk Tolerance: Moderate investors take a medium risk and generally took 5 to 10 years of investment time. These investors are prepared to accept minimal volatility in exchange for returns that will surpass inflation. They want to achieve higher returns but feel uncomfortable taking high market risks.
Conservative Risk Tolerance: Conservative investors are those that are very cautious with their money and take the shallow risk. They don’t want to accept volatility in their portfolio. A financially conservative person always reserves cash for any unwanted situation in the future. Generally, we can take an example of a retired individual that took a minimum risk and save money for their future. Conservative people always follow some set of rules regarding purchasing something.
Risk tolerance depends on few factors. Some of them are given below:
Time Horizon: Time Horizon refers to the period for which the investment is held. It is one of the most critical factors affecting risk tolerance. Every investor has an investment plan, so the time horizon varies for each of the investors. The more time an investor has, the more aggressive the investment approach they can follow, while the investment approach is conservative in less time.
Portfolio size: Risk tolerance directly depends on the portfolio sizeâ€”the larger the portfolio size, the more risk an investor can take. A wealthy investor can bring more trouble than the less well-off investor as wealthy investors are not dependent on the investment money for their daily needs while the latter is.
Goals: Each investor has its plans to fulfill. To achieve these goals, they make specific investment strategies and follow risk tolerance accordingly.
Investment Experience: Are you new to investing, or do you have extensive experience in investment? Risk tolerance largely depends on the Investment experience of the investors. More experience an investor has, the more risk tolerance he can take while preserving the capital.
Nowadays, many advisory firms use online risk tolerance questionnaires to measure their client’s risk tolerance and meet their requirements. A Risk tolerance questionnaire consists of a set of survey questions that helps the investors and their clients also.