Risk tolerance is an essential element in investment science. The study of risk tolerance has been of interest to investors and academics for hundreds of years. Before you start investing, it is important to honestly assess your risk tolerance.
Risk tolerance is the degree to which an investor is willing and able to accept the large swings in the value of their investments. Factors affecting risk tolerance are age, investment time-frame, quantum of risk capital, investment experience and investment objectives.
This is often known as ‘age-based’ investment risk tolerance. Conventional wisdom says that a younger investor has a long-term time-frame and can take more risk. Both the age and time-frame for meeting specific financial goals play an important role in determining an investor’s risk tolerance. If an investor is young and has a long time to meet investment goals, he may have a higher risk tolerance than someone who is nearing retirement and is counting on investment income to live on for one or two decades.
Risk capital is that portion of money available to invest or trade that will not affect one’s own lifestyle even if that amount is lost. Available risk capital and the current net worth of an investor are the important considerations when determining investment risk tolerance. Net worth is simply an investor’s assets minus liabilities. Generally, an investor with a high net worth can assume more risk. The smaller the percentage of your overall net worth the investment or trade makes up, the more aggressive the risk tolerance can be.
Factors such as personality, personal experiences and current financial circumstances also come into play. For instance, if you are a single parent, are responsible for the care of a sick or elderly relative, or have lived through a period of economic upheaval, such as a major recession, you may be a more risk-averse or conservative investor. On the other hand, if you have a promising career, a generous salary and little in the way of financial responsibilities, then you may be more comfortable in assuming greater investment risk.
Keep in mind that investment risk does not mean staking your life savings on highly speculative investments like investing in a new company that a friend is starting. The only money you would want to put in investments like that is money you can afford to lose.
But it does mean getting used to the fact that virtually all investments that have the potential to provide substantial returns will drop in value at one time or other, sometimes significantly. Hence, every investor needs to determine what kind of investment strategy is appropriate given his or her risk tolerance level.
The writer is an associate professor in finance and accounting at IIM Shillong