Risk Tolerance of an Investor – Understanding Risk & Types

In this article, we will understand about risk tolerance of an investor in detail.

What is risk tolerance?

From an investment perspective, risk tolerance is nothing but an investor’s ability to take or ‘tolerate’ risks. There are many investments that are market-driven – like ELSS. There are also investment schemes that offer steady returns regardless of the market movement. But all investments are ‘risky’ (yes, even the safe ones like FD) and it is up to the investor to decide how much he is willing to put at stake.

People with a long-term investment horizon (usually, investors in their 20s or 30s) can afford to be aggressive risk seekers. If the investor is nearing retirement or is interested only in short-term financial goals, they will prefer safe avenues that assure capital protection, albeit with lesser returns. However, higher rewards often come with higher risks. For instance, if you are planning to delve into mutual funds, stocks or bonds, please understand that returns are not guaranteed and may vary from one period to another. However, returns would be way higher than traditional investment avenues.

How to understand your risk tolerance

Investments and savings are for a financially comfortable future. No financial institute encourages you to invest by compromising your current basic comforts. It is important to enjoy the process of seeing your money grow towards your goal. For this, you should understand your risk tolerance, which is as diverse as people’s fingerprints. Instead of leaving it to the official from the respective bank or financial institute to figure out your risk profile and suggest plans accordingly (often biased), you can do it on your own online or by asking yourself a list of questions.

a. For how long are you planning to invest?

If you are 25 years old and plan to retire by age 60, you have 35 years to invest and save. It is possible that you can stomach a few market ups and downs. You might be willing to take moderate to high risk to earn inflation-beating returns. Now, one cannot expect this if you are, say, in your 50s and just have a few years before you retire.

b. How many years are you planning to work?

There is no easy answer to this, though you can safely assume that you will retire by 55 or 60. If you are planning for an early retirement to follow your passion (like starting your business, writing a novel or travelling), your investment responsibility too doubles. So, going for a pension plan that can meet your needs accordingly is a must. Indeed, financial crunch during later years is not a pleasant experience.

c. Have you considered possible expenses during golden years?

If you already have a house or will have one by then, that is one less thing to worry about. Yet, there are regular living expenses to consider like healthcare and keeping your dependents comfortable among others. Think how much monthly income (pension) you might need – use a retirement calculator to find out how much you need to invest until retirement to reach that goal. This is another way to understand your risk-taking ability.

d. What is your reaction when there is a market high?

Giddy with happiness and couldn’t wait to celebrate – if this is close enough, do remember that you will earn money only when you sell your assets. This can take years. Do you tend to invest as per the market movements? This shows that you are an aggressive risk seeker.

e. How do you take the news of a market low?

Dismay? Despair? Dread? Well, this somewhat shows that you cannot handle the risk. However, you must also remember that your money is still where it is until you sell your stocks. Sometimes, even if the stock prices take a hit, it could be worthwhile to invest in them if there is a chance of market rise. In fact, the strategy of ‘buying low and selling high’ has worked for many in the past.

Categorizing risk tolerance

It’s helpful to categorize your risk-leanings so that you can choose investment schemes accordingly. Go through the below 3 categories of risk-tolerant to understand which category you belong to.

a. Aggressive
Everyone knows at least one market savvy person who religiously comb through finance newspapers and follow the market movements to the T. If you think you are one, you are an aggressive investor. You understand the workings of underlying securities and the trends. You know just when to put your hands in a volatile investment just to pull out at the right time with supremely high returns. You are not scared to invest in shares of small companies that shows immense growth potential. Do these statements strike a chord?

b. Moderate
These are people who are willing to take moderate risks that do not rock their boats, but earn moderate to high returns. They go for a balanced approach when it comes to investment horizon (say, 5 to 15 years) as well as assets they plan to invest. For instance, they often prefer large enterprises as opposed to small companies or startups.

c. Conservative
Conservative or low risk tolerant will try to keep the volatility factor as low as possible. Capital protection with some kind of returns is their priority. So, they often choose money market instruments like FDs. Their investment horizon will be low and hence unwilling to take ‘unnecessary’ risks when close to retiring age.

Why change portfolio as per risk profile

Building well-diversified portfolios that cater to an investor’s needs requires not just market knowledge but also expertise in risk management. Your investment objectives evolve constantly and investment horizon become lesser and lesser with time.

Market fluctuations is another ball game altogether. So, the portfolio too should change accordingly. For instance, the kind of risks you were willing to take at the age of 25 may not appeal to you at the age of, say, 40. With changing priorities and responsibilities, the investment goals too will change. For this reason, it is important for an investor to be attuned to his/her risk appetite. This will help to benchmark risk tolerance without much hassle.