What is risk tolerance?
Why is it important?
How do you determine your risk tolerance?
In this article, we will explore all of these concepts in more detail.
We will also explain the psychology of risk tolerance for investors and some ideas to increase or decrease risk tolerance.
This can help fearful investors take the first step and help gamblers reduce their risk.
By the end of this insightful read, you will have a good understanding of risk tolerance and how it impacts your investment decisions.
So let’s get started!
What is risk tolerance?
Risk tolerance is the degree of variability in investment returns that an investor is willing to experience.
It is often measured as the amount of loss an investor is willing to take before selling an investment.
For example, an investor with a low-risk tolerance may only be willing to lose $100 on an investment before selling, while an investor with a high-risk tolerance may be willing to lose $500.
Therefore, risk tolerance is a measure of an individual’s willingness to take on risk.
Why is risk tolerance important?
Risk tolerance is important because it impacts how you invest and can have a big impact on your financial future.
If you have a low-risk tolerance, you may only invest in safe, low-risk investments like bonds and cash.
On the other hand, if you have a high-risk tolerance, you may be more willing to invest in stocks and other higher-risk investments.
Knowing your risk tolerance is important so that you can make informed investment decisions.
This is because if you invest in an asset that requires a higher risk tolerance, you would be more likely to panic and sell when volatility (market swings) occurs.
Thus, it is important to only invest in assets that are appropriate for your risk appetite.
It allows you to stay the course during market corrections and bear markets when everyone else is selling.
Understanding your risk tolerance is the key to success as an investor.
Risk tolerance is also important because there will inevitably be some form of risk present in all investments.
If someone has extremely low-risk tolerance, they might become a victim of “paralysis by analysis” and never invest.
This would be a mistake, as even “safe” investments like bonds have some risk associated with them.
On the other hand, someone with too high of risk tolerance might take on more risk than they can handle and end up losing everything.
This is why it’s important to find that happy medium where you’re taking on enough risk to potentially earn a higher return, but not so much risk that you’re putting your entire investment portfolio at risk.
How to determine my risk tolerance?
There are several ways to measure risk tolerance. One common method is to use a questionnaire or survey.
This allows investors to rate their comfort level with different types of investments, such as stocks, bonds, and cash.
For example, on a scale of 1 to 5, an investor might rate their comfort level with stocks as a 3.
This means that they’re willing to take on some risk but would prefer to avoid volatile investments.
Here’s a quick example test to see if you have a high-risk tolerance.
- Are you comfortable with losing all your money for a larger gain?
- Do you like roller coasters?
- Do you like to gamble?
If you answered “Yes” to any of the above questions, then you likely have higher risk tolerance. This means that you’re more willing to take on risks in your investments.
A good question I always ask my friends when they’re unsure is; “How much money are you okay with losing?”
You’ll hear answers ranging between 5% – 50%.
This is a good indicator to determine how much risk you should be taking.
Another way to measure risk tolerance is by looking at someone’s investment history.
This can give you a good idea of how much risk an investor is willing to take on.
For example, someone who has mainly invested in stocks over the years is likely to have a higher risk tolerance than someone who has only invested in bonds.
Risk tolerance can also be measured by looking at an investor’s age and investment goals.
Generally, younger investors have a higher risk tolerance than older investors because they have more time to recover from any losses.
However, this may not always be accurate as some young investors may be more risk-averse than others.
Similarly, investors with longer-term investment goals are often willing to take on more risk than those with shorter-term goals.
This is because they have a longer time horizon to ride out any market volatility.
Finally, ask yourself how often you worry about your investments and if you can sleep soundly with your decisions.
If you’re constantly worrying about your investments, then you likely have a low-risk tolerance.
Your investments will likely be too volatile for your comfort level and emotional well-being.
On the other hand, if you’re comfortable with your investment decisions and don’t worry about them often, then you likely have higher risk tolerance.
You might be in investments that can make you a lot of money but the potential loss does not bother you.
With that being said, a high-risk tolerance does not mean that you should be completely careless with your money.
It is still important to do your research and make sure that you’re investing in quality assets.
Just because you’re willing to take on more risk doesn’t mean that you should invest in anything and everything.
What factors influence risk tolerance?
Several factors can influence an individual’s risk tolerance. These include age, income, investment goals, and stage in the life cycle.
As mentioned earlier, age is inversely related to risk tolerance—the older you are, the more conservative you tend to become.
This is because younger people have more time to recover from financial losses.
Income also affects risk tolerance. Earners with higher incomes can afford to take on more risk than those with lower incomes.
Investment goals also play a role in risk tolerance.
Investors who are trying to grow their wealth may be willing to take on more risk than those who are trying to preserve their wealth.
Finally, your stage in the life cycle can also affect risk tolerance. Those who are settling with a family might be more risk-averse than those who are still single.
What is the difference between risk and uncertainty?
Risk and uncertainty are often used interchangeably, but they are not the same thing.
Risk is quantifiable—you know the probability of something happening and the potential downside if it does.
Uncertainty, on the other hand, is unquantifiable—you don’t know what’s going to happen or how bad it could be.
For example, there can only be 21 million Bitcoins so the risk of Bitcoin’s value depleting due to an increase in money supply is 0.1%.
The 0.1% comes from the possibility that somebody could invent a quantum computer that could break the encryption.
This is a quantifiable risk that can be assessed with probabilities.
On the other hand, a new government regime decades from now might come into power and start persecuting people who own Bitcoin.
This is an unquantifiable risk because it’s impossible to know what will happen or how bad it could be.
In general, investors are more comfortable with risk than uncertainty because risk is easier to assess and manage.
You can allocate resources to mitigate risks, but you can’t do the same with uncertainty.
How To Increase Risk Tolerance When Investing
Becoming more educated about investing is one of the best ways to increase risk tolerance.
The more you know about investing, the less risky it will seem.
Another way to increase risk tolerance is to start small.
By investing a small amount of money, you can get comfortable with the idea of investing without putting your financial security at risk.
Finally, remember that you can always adjust your risk tolerance level.
If you start out investing in low-risk investments and find that you’re comfortable with them, you can gradually start moving into higher-risk investments.
On the other hand, if you start out investing in high-risk investments and find that you’re not comfortable with the risk, you can always move into lower-risk investments.
How To Decrease Risk Tolerance When Investing
To decrease your risk tolerance, it can be helpful to review the worst-case scenarios of your investments.
Often, the fear of losing money is much worse than the actual loss itself.
By understanding the risks involved with your investments, you can put them into perspective and make more informed decisions about how much risk you’re willing to take on.
Finally, don’t be afraid to play devil’s advocate.
When making investment decisions, it’s important to consider all sides of the argument.
This will help you make more balanced decisions that take into account both the potential upside and downside of an investment.
The Psychology of Risk Tolerance
Typically humans feel more pain when they lose money than the pleasure they receive when they gain the same amount.
This is called loss aversion, and it can impact an investor’s risk tolerance.
An investor’s risk tolerance may also be influenced by their investment goals. For example, an investor who is saving for retirement may have a different risk tolerance than an investor who is trying to grow their wealth quickly.
Investors may also have different risk tolerances based on their personality type. Some people are more comfortable with risk than others.
For example, someone that is more impulsive may be more willing to take on risks than someone that is more analytical.
There are a few things that an investor can do to assess their risk tolerance.
One is to consider their investment goals and what they are trying to achieve. Another is to look at their past investment behaviour.
This can give clues as to how they may react in different market conditions.
Past experiences can also change someone’s risk tolerance.
For example, someone who lost a lot of money in the stock market may become more risk-averse and be less likely to invest again.
Competitive pressures may also lead investors to take on more risk than they are comfortable with.
For example, if everyone else in their social circle is investing in a certain stock, they may feel pressure to do the same.
Seeing others with more wealth might also distort an investor’s perception of what is considered a normal or acceptable level of risk.
Inadequacy feelings may also contribute to an investor’s risk tolerance.
For example, someone who feels like they don’t have enough money may be more likely to take on risks to try and grow their wealth.
It is important to note that risk tolerance is not static. It can change over time based on an investor’s circumstances and experiences.
For example, if someone did not have debts or a family to care for, they may be more willing to take on risks.
It is also worth noting that an investor’s risk tolerance may not always align with their investments.
The adrenaline that some investors might receive can come from outside of the markets which leads them to make safer investment choices.
On the contrary, some investors may have a higher risk tolerance for their investments but not in other areas of their life.
At the end of the day, it is important to know your risk tolerance and to invest accordingly.
Taking on too much risk can lead to losses, while not taking on enough risk may mean that you miss out on potential gains.
These losses can cause both psychological and financial damages. The gains can also lead to confidence and a false sense of security.
It is important to find a balance that works for you and to stick to it.
Conclusion
Risk tolerance is an important concept for investors to understand.
It can help them make better investment decisions and avoid making mistakes that could hurt their financial goals.
Remember that a high-risk tolerance does not mean someone is a better investor and a low one doesn’t mean that someone can’t make a lot of money.
It’s all about finding the right balance for you and your unique circumstances.
But despite your risk appetite, you should always be prepared to lose all your money when investing.
Risk tolerance merely helps you decide what asset allocations you should opt for.
However, there’s always a probability that the money you invest will go to zero, despite choosing even the safest options.
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