Introduction
The term risk tolerance refers to the amount of loss an investor is ready to handle while deciding on investing in a project. It’s the degree of variability that an investor keeps in his financial mind that can occur in the outcome of the project. Considering risk tolerance is a crucial component while planning to invest in any project because it gives a realistic picture of the outcomes of that project.
An old Wall Street Adage says, “You can eat well or sleep well.” In this quotation, eating well refers to the investor’s willingness to hold high-risk assets after a prolonged observation. It can help them to generate a significant amount of money as stocks don’t stay stable for a long time, which can be a sleep loss for investors.
High-risk tolerance often refers to EFTs, equities, and equity funds. In contrast, Low-risk tolerance is synonymous with EFTs, bond funds, and bonds.
Risk tolerance can help the investor make a good project strategy. For instance, if he wants to keep risk tolerance low, he will put low-risk investments more and least on high-risk investments.
Factors Affecting Risk Tolerance
These are the following factors that affect risk tolerance a lot:
- Goals
- Timeline
- Level of Investors’ Comfort
- Portfolio size
- Age
Goal
Every individual has a different financial goal. For many investors, making the highest possible money is not the sole purpose of investing. So, the risk tolerance varies according to the investor’s goal for his project.
Timeline
According to investment plans, different investors have different time horizons. For example, a person wants to achieve a goal within the next 15 years while another person wants to achieve the goal in the next five years. So, the one with more time will take fewer risks while the one with less will take more risks.
Level of Investors’ Comfort
The way to handle the risk varies from investor to investor. Taking a considerable risk doesn’t bother some investors, while others get upset. Risk tolerance is directly proportional to the comfort level of the investor.
Portfolio Size
The investor with an extensive portfolio is likely to take more risks than the one with a small portfolio size. Suppose there is an investor with $10 million who can take more risk than the one with a $1 million portfolio. The drop in value affects the small-size portfolio most compared to the extensive portfolio.
Types of Risk Tolerance
Following are the types of risk tolerance:
- Moderate risk tolerance
- Conservative risk tolerance
- Aggressive risk tolerance
Moderate Risk Tolerance
Moderate risk investors keep risk tolerance less than aggressive risk-taker investors. They don’t take many risks in their project and make a whole percentage of losses they can bear. Moderate risk investors pursue a 50/50 structure by combining riskless securities, less volatile bonds, and company mutual funds. They take a little risk and also take care of growth.
Conservative Risk Tolerance
Some investors keep the stability of their portfolio as their priority. They are concerned about protecting their capital. Conservative risk-tolerant investors don’t want fluctuation in their investment. A low return rate in exchange for their capital preservation is more comfortable.
Aggressive Risk Tolerance
Aggressive risk-tolerant investors take huge risks because they are well versed in the market. This type of investor has large downward and upward fluctuations in their portfolio. Investors who take aggressive risks are known to be experienced and wealthy, and according to their experience, they have a broad portfolio.
Because aggressive investors take a significant risk, they generate a lot when the market does well. If the market loses its potential, it has to face a considerable loss. But as they have an idea about it, they know how to tackle this loss.
Determination of your Risk Tolerance
Answering the following questions can help you to determine your risk tolerance:
What Are the Objectives Behind Your Investment?
Do you want to see the growth of your nest egg by investing regularly? Or are you ready to see massive changes, both positively or negatively? Do you want to preserve your investment? Answers to these questions will help you determine the level of risk you can handle.
What Will Be Your Reaction if You Lost 20% in Your Portfolio?
To assess the level of risk, you must think about worst-case scenarios and the hypothetical challenges you can face. If the loss of 20 percent will affect you? Whether it will take your appetite or sleep away, you can gather your courage again and will reinvest with the same enthusiasm.
Conclusion
If an investor doesn’t consider the risk, tolerance can prove fatal for investment. So, considering risk tolerance is essential to make a good strategy and to see a project’s positive or expected outcome.
