Risk Tolerance

It is the amount of loss an investor is willing to take on when making an investment decision

Risk tolerance is the amount of loss an investor is willing to take on when making an investment decision. The process of recognizing, evaluating, and controlling risks to an organization's goals is known as risk management.

These risks may result from many factors, such as monetary uncertainties, legal liability, human error, or natural disasters. Individuals may determine their project's aims, strengths, and weaknesses with effective risk management solutions. 

For a project to be successful, an individual must understand potential dangers and how to mitigate them. Effective risk management strategies depend on the situation and the actions of the businesses assuming the risk.

The best portfolio options for each household depend significantly on their level of risk tolerance. It might also have a significant role in shaping many government policies concerning the exposure consumers face while making financial decisions.

This idea isn't simply applied to the financial sector; the fundamental concept can be used in almost any line of work. How much risk are you prepared to take to achieve your long-term objectives? 

Types of Risks 

Risk in finance is the likelihood that the outcomes will differ from anticipated. Their risk profile determines each investor's resilience and willingness to accept risk. Investors typically expect more enormous profits to make up for increased investment risk.

Systematic and unsystematic risk are the two basic types of risk. Systematic risk is the market unpredictability of an investment. It represents outside factors that impact all businesses in a given sector or group. 

The asset-specific risks that can impact an investment's performance are unsystematic risks.

Following are the types of risks that financial analysts come across when proposing investment opportunities-

  • Political/Regulatory 

  • Management

  • Legal 

  • Competition 

  • Country

  • Social 

  • Operational

  • Financial 

  • Interest Rate 

  • Environmental 

Types 

Depending on how much risk they are willing to take, investors are typically divided into three categories: conservative, moderate, and aggressive.

1. Conservative

The most risk-averse investors in the market are called conservative investors. They choose investments they believe to be the safest and never engage in risk. 

Financial stability and wealth preservation are essential priorities for conservative investors. Change and uncertainty make them uncomfortable.

An example of this is selling securities the moment prices start falling. 

Since their motivations are primarily emotional, conservative investors are challenging to advise. As long as the danger is manageable, they typically profit from the additional risk that an expert advisor persuades them to accept.

Michael M. Pompeian, in his paper "Risk Tolerance and Behavioral Finance," writes that the conservative investor's bias tends to be emotional- including status quo, loss aversion, and endowment bias. 

In loss aversion bias, conservative investors tend to feel the pain of losses more than the pleasures of gains. Status quo bias means they often try to keep their investments the same.

2. Moderate

Moderate risk investors are relatively more risk-tolerant when compared to conservative risk investors. 

Advisors shouldn't bombard them with too many investing suggestions because they frequently overestimate it.

Their objective is to balance possibilities and risks, and this investor's strategy is occasionally referred to as a "balanced" one. Typically, moderate investors create a portfolio with a 50/50 or 60/40 split between equities and bonds.

A 60/40 structure means an investor may invest 60% in stocks, 30% in bonds, and 10% in cash. According to Pompeian, behavioral biases of moderate investors are mostly cognitive-recency, hindsight, framing, regret aversion, etc.

Recency bias predisposes us to recall and emphasize recent events or observations and extrapolate patterns where none exist. Hindsight bias occurs when an investor perceives past investment outcomes as if they had been predictable.

Framing bias is the tendency of an investor to respond to situations differently based on the context in which they are presented. 

3. Aggressive

Investors that take significant risks and invest aggressively are knowledgeable about the market. It is common knowledge that aggressive investors are well-off, knowledgeable, and typically have a diverse portfolio.

They take on a lot of risks, so they benefit when the market is doing well and lose a lot of money when the market does poorly. Such investors are accustomed to their portfolios, experiencing significant increases and decreases. 

They are quick decision-makers; they chase high-risk investments. They are the most demanding clients to advise because they like to control and get deeply involved.

Commonly, equities make up this investor's asset allocation with short bonds or cash. According to Pompeian, behavioral biases of aggressive investors are overconfidence, self-control, affinity, outcome, and illusion of control.

Self-control bias is the tendency to consume today at the expense of saving tomorrow. Affinity bias refers to investors' tendency to make irrationally uneconomical consumer choices.

Outcome bias occurs when the investor focuses more on the outcome of the process rather than the process itself.

It has many related terms: risk capacity, risk propensity, risk preference, risk attitude, risk aptitude, risk perception, risk appetite, and risk threshold. 

Out of these, the most overlap comes with risk appetite and risk threshold. The following are the comparisons and the reason why it is an ambiguous term-

1. Risk Appetite Vs. Risk Tolerance

Risk Appetite is a very recent term. Appetite means hunger, and risk appetite implies the desire to take risks. 

An organization with a large appetite for risk has decided that pursuing opportunities with more significant uncertainty is worth the more considerable potential benefit.

In the opinion of an organization with a low-risk appetite, the optimal course of action is to avoid risk altogether. Tolerance means how much you are prepared to bear.

For example, it is tolerable when a customer demands small requirement changes in a deal, but when they require significant changes, it becomes intolerable. This is measured in terms of how much you are willing to bear, similar to risk appetite.

2. Risk Threshold Vs. Risk Tolerance

The risk threshold is related to measurable risk. It entails putting an upper and lower limit on the risk an organization is willing to take. In other words, if the risk exceeds the threshold, the company won't allow it.

A risk threshold involves measuring something with a tolerance of upper and lower boundaries of possible outcomes.

For example, you intend to submit a proposal for a contract, and you estimate that it will be worth around $150,000. Your company has informed you that, due to financial restrictions, they cannot let you exceed $170,000. Your risk threshold, in this case, is $20,000.

Important Note

Risk capacity is a financial term. It is an investor's financial ability to take risks.

Factors Affecting Risk Tolerance

Many factors increase, decrease, or affect an investor's risk tolerance. Some of the elements are mentioned below: 

1. Portfolio Size and Financial Standing

It increases with portfolio size. Investors with a large ratio of assets to liabilities are more likely to take more significant risks since they can afford to lose money.

Inversely, an investor with more liabilities will have lower risk.

2. Age

One of the factors that influence the willingness to accept risk the most is age. Young people are typically able to take more risks than older adults.

Young people have the potential to earn more money at work and have more free time to respond to changes in the market. They have more time and resources to bounce back from losses.

On the other hand, a person close to retiring lacks time, money, and help to recuperate from the failures.

3. Disposable Income

A person with more disposable income is more likely to take risks than someone with less disposable income. It is caused by the same reason as mentioned above, and there is more room to suffer loss and volatility when you have more funds to invest. 

It is a subjective factor and may not hold for all individuals. An investor with a high disposable income might have a low-risk in terms of tolerance.

4. Goal

Each individual has a different risk tolerance based on their goals. Achieving the highest gains may not be the goal for every individual. For some, it might be to complete specific improvements based on their plans.

5. Time Horizon

Each investor will choose a different time horizon depending on their investment intentions.

An individual with a longer time horizon typically has a high-risk tolerance. Market volatility is significant in the short term but has little impact on returns over the long term. 

In a short time horizon, however, investors choosing high-return investments such as equities are exposed to many risks. 

Evaluating Risk Tolerance 

Individual investors tend to be trend followers rather than accurate forecasters when making asset allocation decisions. 

Adequate diversification considerably reduces the likelihood of total loss. Investors must evaluate their risk and understand the optimal proportion of asset allocation (efficient frontier). 

A financial advisor can help anyone from young individual investors to financial institutions. Your investment goals must also be considered when figuring out how much risk to accept.

Apart from the factors listed above, a financial advisor can evaluate financial institutions' risk tolerance by looking at their past investments and emotional responses to risks. A questionnaire is usually performed to collect an investor's reactions to different situations.

It could entail evaluating their time horizon, available assets, and need for income, as well as their ability to withstand market volatility and degree of comfort in maintaining their investment over the long term. Based on this, the advisor can conclude how much risk they are willing to take.

If we evaluate an investor as too aggressive or too conservative, an incorrect risk threshold may be set and, in turn, the wrong risk-management approach. A change in risk threshold requires emotional intelligence. 

Such a change in the individual's attitude can help increase or decrease risk tolerance. 

Risk Tolerance and Entrepreneurship

Entrepreneurs are needed to challenge the status quo. Without a high tolerance for risk, it is hard to launch your own business. 

Types of risk that an entrepreneur might face: 

  • Time risk: The amount of time it will take to turn a new idea into a product that will be suitable for the market.

  • Competitive risk: The likelihood that a competitor will be selling the same or similar goods on the market, and the success of rivals in similar marketplaces

  • Investment risk: The cost of starting a new business; in other words, if the entrepreneur has access to sufficient funding to allow the enterprise to last long enough. 

  • Technical risk: The technology is involved in developing the product to make the sound quality in the market. 

People who think they'd become great entrepreneurs frequently end up being terrible, not because they lack knowledge, talents, or networks, but because they cannot take calculated risks when things become challenging.

It is a skill that may be developed and used with reason; it is not a fixed characteristic. You can and should take proactive steps to raise your risk tolerance and become accustomed to the uncertainty and precariousness of your chosen road.

Target Date Fund

Participants select the date they intend to retire, and the fund adjusts the portfolio over time with this goal in mind.

According to the theory, investors become more cautious about their investments as they move closer to retirement. Therefore, the fund gradually reduces the percentage of the portfolio invested in stocks over time. 

There are many variations in the mechanics of these funds built. The idea is sensible and workable as long as fees are kept to a minimum.

These funds allow customization based on the investor's age, a known characteristic. If the investor doesn't actively change the fund, the goal date will be based on a reasonable assumption about when someone that age wants to retire. 

Target date funds also protect many investors from their instincts which is panic when stock prices fall.

Investors have consistently demonstrated a fantastic ability to time their investing decisions incorrectly throughout the history of defined contribution retirement plans. 

They appear to be following a flawed strategy of purchasing high and selling low in the end.

According to Morningstar, a financial research firm, the average fund investor lost roughly 0.5 percent annually due to poorly timed trades in 2019.

Key Takeaways

  • It is the amount of risk an investor is willing to take when making an investment decision. 

  • Many action strategies depend on the situation and actions of the businesses assuming the risk.

  • Depending on how much risk they are willing to take, investors are divided into three categories: conservative, moderate, and aggressive.

  • When measured in terms of how much you are willing to bear, it is similar to risk appetite.

  • The risk threshold is when risk is measured with a tolerance of upper and lower boundaries.

  • If we evaluate one's willingness to accept risk as too aggressive or too conservative, we set up an incorrect risk threshold and, in turn, create the wrong risk-management approach.

  • It is a skill that may be developed and used with reason; it is not a fixed characteristic.

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Researched and authored by Ishpreet Kaur | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

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