Risk tolerance is a topic that comes up often in business-related talks. However, it’s rarely defined accurately, which is why today we are going to focus on it. We will have a look at its definition and then see a couple of examples to help you understand the concept better.
Risk Tolerance Definition
The risk tolerance is a specific measure of the degree of uncertainty that the investor is willing to accept when it comes to negative changes in its business or assets. The investor should have a realistic understanding of the ability and willingness to face large swings in the investments they make.
Here you have a short clip explaining the concept in detail:
Types of Risk Tolerance
Generally, there are several degrees of risk tolerance: aggressive, moderate, or conservative.
Usually, aggressive investors are market-savvy. They understand deeply the securities, as well as their propensities, so they can buy volatile instruments. For example, they take the risk of purchasing small company stocks that can go down to zero very fast. Usually, they go for maximum returns that also come with maximum risk.
Moderate investors accept some risk but have a rather balanced approach. They have intermediate-term time horizons that vary between 5 and 10 years. Most of the time, moderate investors look for a 50/50 structure of large-company mutual funds and riskless securities.
Conservative investors accept little to no volatility in the investment portfolios they have. Usually, the retirees who spent years working on their achievement don’t want to take any kind of risk. They tend to target liquid and guaranteed vehicles. To preserve the capital and allow for income, they head for bank certificates of deposit (CDs), U.S. Treasuries, or money markets.
Risk Tolerance vs Risk Capacity
There is an important difference between risk tolerance and risk capacity. Unlike the first concept, risk capacity refers to the risk you can afford to take. For example, you can be comfortable with an aggressive, high-risk portfolio. However, if you are just a couple of years away from the investment goal (for example, retirement), you may not want to have a portfolio of just stocks. In this case, you need a more conservative portfolio to preserve the investment assets you need.
At the same time, if your retirement savings are struggling to reach the future retirement goals, a portfolio with 100% stocks may have too much market risk to be okay for this.
Risk Tolerance Examples
1. A High-Risk Investor
One example of risk tolerance is a high-risk investor who wants to tolerate a potential loss of up to 50% of their portfolio. They are doing this to maximize the potential gains.
2. Low-Risk Investor
As opposed to the first example, a low-risk investor doesn’t want to tolerate any potential loss of its capital. Despite being safer, they are restricted to safe investments. For instance, they prefer to stick to insured savings accounts, which are a good option, except that they have some limited potential returns.
3. High-Risk Startup
Naturally, a startup company is being led by people who have a high tolerance for risk. Even though the business can fail, there is also the potential of offering amazingly high returns to the investors.
4. Mega Projects
A mega project can be, for instance, a large bridge, but it can also refer to massive investments. The bridge can have a low risk tolerance since it involves a huge budget, as well as a significant responsibility for the public safety. This kind of project needs an intensive risk management process to make sure they meet the low risk tolerance.
5. Professional Snowboarder
Another concrete example is a professional snowboarder. Most of them have a high risk tolerance and it’s understandable since it’s hard to reach a superior level of snowboarding without risking anything. They invest a lot of time and money in their evolution, and the sport itself isn’t quite a safe one, which is why they risk a lot.
How to Calculate Your Risk Tolerance
On a personal level, everyone has a different propensity for risk. When it comes to business, there are plenty of things that depend on this risk tolerance level. Luckily, if you want to find out more about your own tolerance, there are plenty of online questionnaires. The items included in them may vary a lot, but there are some common elements. Here you have a couple of examples to help you assess this indicator:
- What is your age?
- What do you expect your next major expenditure to be?
- You just won $10,000 on a TV show. Now you must choose between leaving with the sum or betting it all for a 5%, 20%, or 50% chance of winning $100,000, $75,000 and $50,000 respectively. What do you do?
- You expect inflation to return, and the trend has it that you should invest in ‘hard’ assets that historically resisted inflation. However, the only financial assets you have are long-term bonds. What do you do?
- When do you expect to use most of the money you have in your investments?
- Assuming you invest only in one bond, which one do you choose between a high-yield one with a higher interest rate, one that belongs to a well-established company, or a tax-free bond?
- In the next couple of years, do you expect your annual income to decrease, grow, or stay the same?
- Assuming you want to invest in a stock, which one would you choose: one of a company that advances technologically but sell at their low initial price, one from established, well-known companies, or blue-chip stocks that pay dividends?
- Because of a general market correction, one of the investments you made loses 14% of its value soon after you buy it. Do you sell it, hold onto it or buy more of the same investment?
- What investment plan would you choose for your investment dollars?
- Maximum diversity, divide your portfolio among all the available investments, even the ones with the highest return/ greatest risk and the ones with lowest return/ lowest risk;
- Divide your potfolio among two investments that have historically high rates of return, as well as moderate risk;
- Choose the investment with the highest rate of return and most risk.
To draw a conclusion, risk tolerance is an indicator of how much you’re willing to risk if you want to win. There are various levels of this tolerance, as well as plenty of online calculators to help you calculate your own. Finally, it all comes down to every person’s natural tendency towards risk, which reflects in the manner they make business.
Image source: depositphotos.com