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
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.
What is risk tolerance and why is it important? ›
Risk tolerance refers to the amount of loss an investor is prepared to handle while making an investment decision. Several factors determine the level of risk an investor can afford to take. Knowing the risk tolerance level helps investors plan their entire portfolio and will drive how they invest.
What is the correct definition of risk tolerance? ›
Risk tolerance is related to the acceptance of the outcomes of a risk should they occur, and having the right resources and controls in place to absorb or “tolerate” the given risk, expressed in qualitative and/or quantitative risk criteria.
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.
Why is risk ability more important than risk tolerance? ›
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 risk tolerance important in achieving strategic goals? ›
Understanding and managing risk tolerance is integral to decision-making and strategic planning in offering several key benefits: Strategic Alignment: Matching investment strategies with risk tolerance ensures they are in line with corporate goals, making strategic decision-making and resource allocation easier.
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.
How do you interpret risk tolerance? ›
Key points. Risk tolerance includes two essential considerations: your willingness (how you feel about risk) and your ability to take risk, based on your financial situation. Understanding both can help you make more strategic investing decisions.
How do you establish risk tolerance? ›
Setting Risk Tolerances
- Define the boundaries of acceptable performance for significant objectives. Consider strategic, operational, reporting, and compliance objectives.
- Communicate tolerances using existing metrics for measuring performance.
- Implement consistently across operational functions and business units.
A1: A risk tolerance statement helps organisations define their acceptable level of risks, enabling them to make informed decisions aligned with their strategic objectives.
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.
What is the function of 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.
Why do organizations measure risk tolerance? ›
The probability that a risk event will occur can range from highly unlikely to highly likely. Setting the risk tolerance ensures the organization makes risk decisions and manages risk exposures according to established expectations.
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 does risk tolerance affect risk management? ›
A risk tolerance range for minimum and maximum levels of risk is usually set by the committee that oversees the organization's risk management strategy, and is then approved by leadership. High risk tolerance means that an organization is willing to take lots of risk, while low risk tolerance means the company isn't.
Why is acceptable risk important? ›
In engineering terms, Acceptable risk is also used to assess and define the structural and non-structural measures that are needed in order to reduce possible harm to people, property, services, and systems to a chosen tolerated level, according to codes or accepted practice; which are based on known probabilities of ...
What are the key components involved in risk tolerance? ›
There are three key components involved in Risk Tolerance, specifically: 1. Hazard Identification “Did we see it?” 2. Risk Perception “Did we understand that it was a risk?” 3. Risk Tolerance “Did we accept or reject the risk that we perceived?”
How do you deal with risk tolerance? ›
6 Ways to Increase Your Risk Tolerance
- Emergency Fund and Short-Term Savings. ...
- Income Diversification. ...
- Understand Investment History, Theory, and Expected Performance. ...
- Understand All the Risks You Face. ...
- Develop Entrepreneurial Skills. ...
- A Change in Attitude.
Risk tolerance refers to the ability to withstand volatility or fluctuations in returns (Grable & Lytton, 1999; Shah, Khalid, Khan, Arif, & Khan, 2020). However, FRT refers to the minimum amount of uncertainty a person is willing and able to accept in making a financial decision (Grable, 2000; Nguyen et al., 2019).
