All investors should determine the level of risk they are willing to take in their investments. Here’s a guide to help investors understand what risk tolerance is and what kind of investments they should make based on this.
In this article:
- Why Risk Tolerance Varies for Different Investors
- How to Determine Risk Tolerance
- Why Risk Tolerance Matters for Investing
- How to Measure Risk Tolerance
Risk Tolerance | What It Is and Why It’s Important Investors Know About It
What is Risk Tolerance? Simply put, risk tolerance is a term used to describe the level of risk you are comfortable taking in your investments.
Why Risk Tolerance Varies for Different Investors
All investments carry some risk, though some are more conservative than others. Deciding on risk tolerance is extremely complex as lower risk generally offers lower rewards, while higher risk often offers the potential for greater rewards.
Another thing to consider about risk tolerance is that one’s risk threshold may change at different stages in life.
- A younger person with no children and a long career ahead may actually desire higher-risk investments. Not only do they offer higher reward potential investments, but they also are a bit more aggressive and exciting in nature.
- On the other hand, someone approaching retirement age with family responsibilities may have a very low-risk tolerance. People at this stage are seeking to protect their retirement nest eggs and disinterested in investments that could place it in jeopardy.
Essentially, people who have more stable and comfortable financial situations often have more aggressive risk tolerances while those who are saving very carefully for the future tend to have much lower risk tolerances.
Immediately after the “Great Recession,” investors were more reluctant to take big risks as there was a lot of uncertainty concerning the strength of the economic recovery and how long it would last.
Since 2012, though, there has been an upward trend in investors taking above-average risks, according to Investors.com. According to their report, 28% of investors were willing to take above-average investment risks in 2012 and 2013 with those numbers inching up to 29% in 2014 and 30% in 2015.
How to Determine Risk Tolerance
Some people have trouble defining how much they’re willing to risk. After all, it is the retirement nest egg that’s put on the chopping block.
There are things that can help someone gauge their personal risk tolerance scale. For most people, “risk tolerance” and “aversion” fall within a range of acceptable thresholds, which some may refer to as “risk appetite metrics.”
There are three basic types of risk tolerance:
- Aggressive Risk Tolerance
- Moderate Risk Tolerance
- Low-Risk Tolerance
Even within the various types, there are variations in risk comfort zones. Many factors go into determining these levels or risk tolerance for the average investor, such as:
- Length of time available to recoup potential losses
- Future earning capacity
- Existing assets (i.e. other assets such as real estate, trust funds, inheritances, businesses, etc.)
Why Risk Tolerance Matters for Investing
The importance of risk tolerance isn’t always easy to see. However, understanding one’s personal aversion to risk at different stages of the investment journey will help an investor stay within their comfort zone. This also helps avoid what the investor will view as unacceptable losses.
As always, even moderate and low-risk investments carry some risks. However, if you stick with tried and true models and have the time and patience to wait out market fluctuations along the way, these are typically safer investments to make.
Learning where one falls on the scale helps them make investments they’re comfortable with. This also protects their short and long-term investment goals.
Conservative Risk Investments
Conservative risk investments pose the lowest potential risk to the principle of one’s retirement investment.
These are often highly liquid investments that are easy to unload if a sudden need arises. They include things like bank-issued certificates of deposit (CDs), money market investments, and U.S. Treasuries.
Moderate Risk Investments
Moderate risk investing allows for greater diversity and assumes an investment timeline of five to 10 years to recover losses. With this in mind, you may choose a mixture of higher risk investments along with a steady stream of low-risk investments to create balance within your portfolio, with the average split being 50/50.
Some investors prefer a 60/40 split, though. This gives them a little more opportunity to boost their nest eggs. This usually applies to investors who are a little further away from retirement.
Other moderate risk investors prefer a 70/30 split. These may be a little closer to retirement age but not ready to go into full-on defense mode working to protect their principles at all costs.
Aggressive Risk Investments
Investors who have aggressive risk tolerances are often more market-savvy and understand the risks they are taking when making investments, especially when markets are experiencing periods of volatility.
These investors are willing to take maximum risks with the potential of maximum rewards for their efforts. Aggressive risk investing is NOT for the fainthearted or the inexperienced investor.
How to Measure Risk Tolerance
The key is to learn how to calculate risk tolerance. Fortunately, it’s a simple matter, thanks to a variety of online risk profile calculator apps, programs, and questionnaires. These applications and calculators can help investors identify where they fall within the risk tolerance scale.
It’s important to revisit the calculator every few years to see what has changed and to make investment decisions accordingly.
There may be certain complexities that come with investing, but with it also comes the promise of returns. This can go a long way in helping someone prepare for a comfortable lifestyle upon retirement.
Finding the right fit for where one is on the risk tolerance scale and their personal investment goals and philosophy is important when making investment decisions. It also pays to ask questions and thoroughly learn about an investment before deciding on anything.
What kind of investor are you based on your risk tolerance? Are you thinking of switching up your investments for more conservative or aggressive ones? Share your thoughts with us in the comments section below!