What Is Risk Tolerance?
Risk tolerance is the degree of risk that an investor is willing to endure given the volatility in the value of an investment. An important component in investing, risk tolerance often determines the type and amount of investments that an individual chooses.
Greater risk tolerance is often synonymous with investment in stocks, equity funds, and exchange-traded funds (ETFs), while lower risk tolerance is often associated with the purchase of bonds, bond funds, and income funds.
Key Takeaways
- Risk tolerance is a measure of the degree of loss an investor is willing to endure within their portfolio.
- Stock volatility, market swings, economic or political events, and regulatory, or interest rate changes affect an investor's tolerance for risk.
- Age, investment goals, and income contribute to an investor's risk tolerance.
- An aggressive investor commonly has a higher risk tolerance and is willing to risk more money for the possibility of better, yet unknown, returns.
- A conservative investor commonly has a lower risk tolerance and seeks investments with guaranteed returns.
Understanding Risk Tolerance
All investments involve some degree of risk and knowing their risk tolerance level helps investors plan their entire portfolio, determining how they invest. Based on how much risk they can tolerate, investors are classified as aggressive, moderate, and conservative.
Risk tolerance assessmentsare available online, includingrisk-related surveys or questionnaires. An investor may also want to review historical returns for different asset classes to determine the volatility of the various financial instruments.
One factor that affects risk tolerance includes the time horizon for an investor. Having a financial goal with a long time horizon, an investor may have greater returns by carefully investing in higher-risk assets, such as stocks. Conversely, lower-risk cash investments may be appropriate for short-term financial goals.
An investor's future earning capacity, and the presence of other assets such as a home, pension, Social Security, or an inheritance affect risk tolerance. An investor can take greater risk with investable assets when they have other, more stable sources of funds available. Additionally, investors with a larger portfolio may be more tolerant to risk, as the percentage of loss is much less in a larger portfolio when compared to a smaller portfolio.
Aggressive Risk Tolerance
An aggressive investor, or one with a high-risk tolerance, is willing to risk losing money to get potentially better results. Aggressive investors tend to be market-savvy with an understanding of the volatility of securities and follow strategies for achieving higher than average returns.
Their investments emphasizecapital appreciationrather than income or preserving their principal investment. This investor's asset allocation commonly includes stocks and little or no allocation to bonds or cash.
Moderate Risk Tolerance
Moderate investors want to grow their money without losing too much. Their goal is to weigh opportunities and risks and this investor's approach is sometimes described as a “balanced” strategy.
Commonly, moderate investors develop a portfolio that includes a mixture of stocks and bonds, perhaps as a 50/50 or 60/40 structure.
Conservative Risk Tolerance
Conservative investors are willing to accept little to no volatility in their investment portfolios. Retirees or those close to retirement age are often included in this category as they may be unwilling to risk a loss to their principal investment and have a short-term investment strategy.
A conservative investor targets vehicles that are guaranteed and highly liquid. Risk-averse individuals commonly opt for bank certificates of deposit (CDs), money markets, or U.S. Treasuries for income and preservation of capital.
What Is an Example of a 60/40 Portfolio Structure?
A moderate risk-tolerant investor may choose to invest in a 60/40 structure which may include a 60% investment in stocks, 30% in bonds, and 10% in cash.
What Financial Instruments are Considered High Risk Investments?
How Does Risk Tolerance Compare to Risk Capacity?
While risk tolerance measures an investor's willingness to take risk, an investor's risk capacity measures their financial ability to take a risk.
FAQs
It can also be described as their emotional limit, or their willingness to take on a certain level of risk. Risk tolerance is one of the most important components of any investment strategy because it determines the mix of stocks, bonds and cash in the investor's portfolio.
What is risk tolerance and why does it matter? ›
Simply put, risk tolerance is the level of risk an investor is willing to take. But being able to accurately gauge your appetite for risk can be tricky. Risk can mean opportunity, excitement or a shot at big gains—a "you have to be in it to win it" mindset.
Why is it important for you to understand your risk tolerance before you start investing responses? ›
Investments with the potential for higher returns often come with a higher potential for sudden downdrafts or outright loss. With an understanding of your risk tolerance, you can create a strategy for your investments that will help you balance the worries of volatility with the potential for bigger returns.
Why is it important for you to understand your risk tolerance before you start investing Quizlet? ›
Why is it important for you to understand YOUR risk tolerance before you start investing? You should tailor your investment portfolio so that it assumes an amount of risk you are comfortable with.
What are the two factors that can help in determining the risk tolerance? ›
There are two main factors involved with risk tolerance: risk capacity and willingness to take on risk. Conservative portfolios have higher exposure to bonds; aggressive portfolios have higher exposure to stocks.
Why is risk tolerance important? ›
All investments involve some degree of risk and knowing their risk tolerance level helps investors plan their entire portfolio, determining how they invest. Based on how much risk they can tolerate, investors are classified as aggressive, moderate, and conservative.
What is tolerance Why is it important? ›
Tolerance is the ability for someone to endure someone's belief that they may not agree with. Tolerance is important because it promotes a more cohesive, happy society.
How to define risk tolerance? ›
That brings us to risk tolerance, officially defined by the U.S. Securities and Exchange Commission (SEC) as “an investor's ability and willingness to lose some or all of an investment in exchange for greater potential returns.”
What is an example of a risk tolerance? ›
For example, if you have a low risk tolerance, you may sell your stocks the very first time they start to dip. Or, if you like to live on the risker side of things, you may ride through very volatile times just to see how much money you can make.
How do you understand risk tolerance? ›
An aggressive investor, or one with a high risk tolerance, is willing to risk losing money to get potentially better results. A conservative investor, or one with a low risk tolerance, favors investments that maintain his or her original investment.
Key Takeaways
Risk tolerance is about emotional & psychological comfort with risk; risk capacity is about one's financial ability to bear it. Both factors are crucial for crafting a balanced, effective investment strategy. Risk tolerance is fluid and can change due to life events, age, and economic conditions.
Why is it important for you to understand your risk tolerance before you start investing quizizz? ›
Why is it important for you to understand YOUR risk tolerance before you start investing? It's recommended that people with a low risk tolerance shouldn't invest at all. If you have a high risk tolerance, you may be eligible for lower fees since you won't care if your portfolio drastically loses value.
Why do entrepreneurs need risk tolerance? ›
Through effective management of risk tolerance, entrepreneurs can make informed choices, seize opportunities, and navigate the unpredictable journey of entrepreneurship with confidence and resilience.
What are the three elements of risk tolerance? ›
If you find yourself losing sleep worrying about your investments, you may have invested too much or too aggressively. Investors typically fall into three categories of risk tolerance: aggressive (those who are risk tolerant), conservative (those who are risk averse), or moderate (those who are somewhere in between).
Why is getting $100 today is worth more than getting $100 a year from now? ›
The time value of money is a financial concept that holds that the value of a dollar today is worth more than the value of a dollar in the future. This is true because money you have now can be invested for a financial return, also the impact of inflation will reduce the future value of the same amount of money.
How do you manage risk tolerance? ›
Be sure to regularly revisit your risk tolerance decisions. Let you advisor know if there are changes in your life that may affect your risk tolerance. If you're managing your portfolio on your own, assess your portfolio every year to ensure you're still comfortable with the risks you're taking.
What is the meaning of tolerance risk? ›
Risk tolerance is the degree of risk or uncertainty that is acceptable to an organization. Sources: NISTIR 8170 under Risk Tolerance. The level of risk that the Manufacturer is willing to accept in pursuit of strategic goals and objectives.
What describes risk tolerance? ›
You can think of an organization's risk tolerance for a specific initiative as its willingness to accept the risk that remains after all relevant controls are put in place.
Why is risk tolerance important in project management? ›
A high risk tolerance may lead to accepting or exploiting more risks, whereas a low risk tolerance could focus on mitigating or avoiding risks. Project managers must navigate these uncertainties by seeking to align the attitudes of key stakeholders.
What does risk tolerance mean in safety? ›
What is risk tolerance? Risk tolerance is defined as the willingness of a worker or a group to take safety risks. It involves evaluating multiple factors that influence a decision to either accept or reduce risk. Generally, we might have an acceptance of a risk that is too high.
