Understanding Risk Tolerance Before Investing
Joshil Sangtani
Staff Writer
Early investors will look at investments as a gamble, usually focusing on what provides the greatest returns without doing the proper research to see if the investment matches their individual suitability. All it takes is one economic downturn or one change in consumer demand and now an entire portfolio has tanked. The reality of it, is that the only way to make investments that work over the long term, is by first understanding individual risk tolerance. Without knowing how much risk an investor is truly comfortable with, even the greatest investment strategy will fall to pieces when the market becomes volatile.
What is Risk Tolerance?
Risk tolerance is defined as how comfortable an investor is with losing money in the short term, in order to try and gain a higher return over the long run. Essentially, how much can a portfolio go up and down before the investor starts to feel uncomfortable. Someone with a higher risk tolerance is going to invest in volatile investments like stocks or corporate bonds, versus someone with a lower risk tolerance who may lean toward treasury bonds and other fixed income equities. Investing will always involve a level of risk; markets are constantly fluctuating, the value of assets change, and losses in the short term are inevitable. The goal isn’t to avoid risk altogether, but rather understand how much can be handled.
Investors are usually put into one of three categories based on their risk tolerance: conservative, moderate, and aggressive. Conservative investors are risk-averse, prioritizing stability and preserving capital. They are more comfortable with lower returns if it means avoiding large losses, leaning toward safer investments like bonds and stable fixed income securities. Moderate investors are risk-neutral, usually looking to find a balance between growth and stability. These investors are okay with a certain level of fluctuation in the markets as long as it opens up a potential for higher returns. Aggressive investors are risk-seeking, trading volatility for the potential of higher growth and returns. While most likely to invest heavily in equities and high risk assets, they also are fully aware that large volatility is part of the investing process.
Determining Risk Tolerance
Understanding an individual’s level of risk tolerance is important before investing in anything because it impacts reactions that occur when the market moves. Many investors initially think they’re okay with risk when markets are rising, but that same confidence gets shattered once markets decline. For example, during a market downturn, an aggressive portfolio might drop significantly in value. If an investor isn’t comfortable with this level of volatility, they may panic and liquidate at a loss. Reacting off of pure emotion has no place in a successful investment strategy, and the way to minimize the impact of it is by spending time to understand risk tolerance before any investments are made. By aligning investments with tolerance, a disciplined investor is more likely to prevail during all phases of the economic cycle. It’s this discipline that leads to the greatest long-term results.
Determining risk tolerance depends on a multitude of factors, including time horizon, financial situation, reaction, and goals. Time horizon plays a key factor in determining risk tolerance, because long investment timelines (like retirement) have more room to allow for greater risks. More time allows for recovery from market downturns, while short term goals should usually be met with a more conservative approach. One’s financial situation is another important consideration; individuals with stable income and an established emergency fund are going to be better off during market volatility. But if cash is going to be needed in the short term, taking on more risk will lead to an unnecessary financial strain that could be better off avoided. Equally important is one’s reaction to losses. Risk tolerance is misunderstood when the market is expanding and everything seems to go up. The way to actually measure an investor’s reactions, is by seeing how they respond during a market decline. If a large drop in one’s portfolio leads to panic or emotional decisions, then it can be concluded that the current level of risk is too high. The final factor to consider when trying to determine risk tolerance is an individual’s investment goals. Different goals require different strategies, and risk exposure should always align with the end result expected. Ultimately, risk tolerance is seen as both financial and psychological, reflecting not only what can be afforded to risk, but what can actually be handled over time.
Understanding it is not just a technical step in the investing process, but rather the foundation of the investing strategy. While returns are what usually get prioritized, the long term success of your investments will depend on consistency based on how risk-averse an individual is.
Contact Joshil at joshil.sangtani@student.shu.edu