The amount of loss an investor is prepared to handle while making an investment decision
What is Risk Tolerance?
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. For example, if an individual’s risk tolerance is low, investments will be made conservatively and will include more low-risk investments and less high-risk investments.
Summary
- Risk tolerance refers to the amount of loss an investor is prepared to handle while making an investment decision.
- Investors are usually classified into three main categories based on how much risk they can tolerate. They include aggressive, moderate, and conservative.
- Knowing the risk tolerance level helps investors plan their entire portfolio and will drive how they invest.
Factors that Influence Risk Tolerance
1. Timeline
Each investor will adopt a different time horizon based on their investment plans. Generally, more risk can be taken if there is more time. An individual who needs a certain sum of money at the end of fifteen years can take more risk than an individual who needs the same amount by the end of five years. It is due to the fact that the market has shown an upward trend over the years. However, there are constant lows in the short term.
2. Goals
Financial goals differ from individual to individual. To accumulate the highest amount of money possible is not the sole purpose of financial planning for many. The amount required to achieve certain goals is calculated, and an investment strategy to deliver such returns is usually pursued. Therefore, each individual will take on a different risk tolerance based on goals.
3. Age
Usually, young individuals should be able to take more risks than older individuals. Young individuals have the capability to make more money working and have more time on their hands to handle market fluctuations.
4. Portfolio size
The larger the portfolio, the more tolerant to risk. An investor with a $50 million portfolio will be able to take more risk than an investor with a $5 million portfolio. If value drop, the percentage loss is much less in a larger portfolio when compared to a smaller portfolio.
5. Investor comfort level
Each investor handles risk differently. Some investors are naturally more comfortable with taking risks than others. On the contrary, market volatility can be extremely stressful for some investors. Risk tolerance is, therefore, directly related to how comfortable an investor is while taking risks.
Types of Risk Tolerance
Investors are usually classified into three main categories based on how much risk they can tolerate. The categories are based on many factors, few of which have been discussed above. The three categories are:
1. Aggressive
Aggressive risk investors are well versed with the market and take huge risks. Such types of investors are used to seeing large upward and downward movements in their portfolio. Aggressive investors are known to be wealthy, experienced, and usually have a broad portfolio.
They prefer asset classes with a dynamic price movement, such as equities. Due to the amount of risk they take, they reap superior returns when the market is doing well and naturally face huge losses when the market performs poorly. However, they do not panic sell at times of crisis in the market as they are used to fluctuations on a daily basis.
2. Moderate
Moderate risk investors are relatively less risk-tolerant when compared to aggressive risk investors. They take on some risk and usually set a percentage of losses they can handle. They balance their investments between risky and safe asset classes. With the moderate approach, they earn lesser than aggressive investors when the market does well but does not suffer huge losses when the market falls.
3. Conservative
Conservative investors take the least risk in the market. They do not indulge in risky investments at all and go for the options they feel are safest. They prioritize avoiding losses above making gains. The asset classes they invest in are limited to a few, such as FD and PPF, where their capital is protected.
Ignoring Risk Tolerance
Investing without considering risk tolerance can prove to be fatal. An investor must know how to react when the value of investments falls. Many investors flee the market and sell low in the process. At the same time, a market decline can be a great time to buy. Therefore, ascertaining risk tolerance helps in making informed decisions and not make hasty, wrongful decisions.
Additional Resources
Thank you for reading CFI’s guide on Risk Tolerance. To keep advancing your career, the additional CFI resources below will be useful:
FAQs
What is Risk Tolerance? 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.
What does it mean to have a low 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.
What are the three levels of risk tolerance? ›
We can divide investors into three groups based on how much risk they can tolerate: aggressive, moderate and conservative. You may experience all three levels of risk tolerance as you enter new stages of life.
What is tolerance in risk management? ›
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.
What is risk tolerance in entrepreneurship? ›
Risk tolerance is a fundamental concept that pertains to an entrepreneur's disposition and capacity to accept and manage risks associated with starting and running a business venture. It embodies the willingness to undertake uncertainty and potential loss while pursuing entrepreneurial goals and opportunities.
Is it good to have a high risk tolerance? ›
Your risk tolerance plays a crucial role in your game plan for growing your money without stressing about it daily. If you don't have the stomach for dealing with the risks of losing your principal, even temporarily, you'll have to settle for lower-risk investments and the lower returns that come with them.
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 to increase risk tolerance? ›
Table of Contents:
- Number 1: Don't fear risk; understand it!
- Number 2: Go after the data.
- Number 3: Commit to the jump, and work backward from the worst-case scenario.
- Number 4: Share your risk mindset.
- Number 5: Lean into your principles.
Risk tolerance is influenced by some factors that can be measured: the client's time horizon, age, income, and family circ*mstances. Others are less quantifiable, like clients' personalities, their responses to real or potential losses, and their long-term goals and priorities.
What are 3 factors that affect your risk tolerance? ›
By risk profile analysis, the study concluded that FRT is affected by age, education level, marital status, and a number of dependants. According to the study, FRT is defined by the degree of volatility in returns that investors are willing to tolerate for their investment.
“Generally, the higher the risk, the greater your rewards — or losses — could be.” 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.”
Who sets risk tolerance? ›
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.
How can you improve your confidence level and risk tolerance? ›
Increasing risk tolerance involves gradual steps 1. Educate yourself about different types of risks and their potential rewards. 2. Start with small investments or ventures to gain experience and confidence.
What is the risk tolerance theory? ›
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).
What is aggressive risk tolerance? ›
Aggressive Risk Tolerance
An aggressive investor, or one with a high-risk tolerance, is willing to risk losing money to get potentially better results. 1 Aggressive investors tend to be market-savvy with an understanding of the volatility of securities and follow strategies for achieving higher than average returns.
What is the risk tolerance trait? ›
Risk tolerance is a person's willingness to take risks in exchange for the long-term possibility of reward. Data shows that risk tolerance is a consistent personality trait. It doesn't change with market wins or losses.
What does it mean when you have a low tolerance? ›
A low frustration tolerance, sometimes abbreviated LFT, can make you feel overly sensitive and easily flustered. But it's not just your personality. Frustration tolerance is a component of emotional regulation skills. When it's low, you find yourself bothered, angry, or thrown off by routine stressors.
What does it mean to have a low tolerance level? ›
Low frustration tolerance (LFT), or "short-term hedonism," is a concept utilized to describe the inability to tolerate unpleasant feelings or stressful situations. It stems from the feeling that reality should be as wished, and that any frustration should be resolved quickly and easily.
What does it mean to have a low distress tolerance? ›
What we mean by distress intolerance is a. perceived inability to fully experience unpleasant, aversive or uncomfortable emotions, and is. accompanied by a desperate need to escape the uncomfortable emotions. Difficulties tolerating distress are often linked to a fear of experiencing negative emotion.
What is the meaning of low risk? ›
: not likely to result in failure, harm, or injury : not having a lot of risk. low-risk investments. 2. : less likely than others to get a particular disease, condition, or injury. low-risk patients.
