Risk tolerance pertains to an investor's readiness to endure potential losses when making investment choices. Investors are typically categorised into three primary groups according to their tolerance for risk: aggressive, moderate, and conservative.
It is no secret that the securities market is subject to fluctuations based on a variety of factors. As a result, all market-linked investments carry a certain degree of risk; while some instruments carry high volatility and high risk, others are relatively less volatile and, therefore, less risky. An investor has to consider several factors while selecting an investment instrument for their portfolio, one of which is risk tolerance.
What does risk tolerance mean?
Risk tolerance is the magnitude of the risk an investor is willing to undertake during the course of an investment. Let us understand what is risk tolerance with the help of a simple example. Investor A wishes to invest Rs. 10,000 in the securities market for two years. One of the main criteria they are concerned about while selecting an investment avenue is the degree of risk.
The maximum loss A is willing to expose their portfolio is 10%, that is, Rs. 1,000. Therefore, they end up choosing an investment option that has a historical record of less than 10% loss. Risk tolerance is, thus, one of the primary factors that drive the selection of an investment instrument. Having clarity on one's risk tolerance helps an investor select the right investment options, and also enables them to restrict their potential loss (subject to market volatility).
How risk tolerance works
Understanding risk tolerance is essential in investing. While many may perceive themselves as having a high risk tolerance when markets are bullish, the true measure comes during downturns. Consider the events of March 2020 when the market plummeted due to the COVID-19 pandemic. This period tested investors' risk tolerance: those who sold stocks amid panic likely had low risk tolerance, while those who capitalised on the market decline demonstrated high risk tolerance, which proved advantageous as the market rebounded strongly in 2021. Similarly, the turbulence of 2022, driven by rising interest rates, further examined investors' risk tolerance as stocks and bonds experienced significant declines.
Also read - What is a Risk Profile?
Factors affecting an investor's risk tolerance
Different investors have varying degrees of risk tolerance. While some investors are open to assuming a high degree of risk in the hopes of high returns on their investment, others are risk averse and wish to protect their principal investment to a certain degree. There is a wide array of factors that have a bearing on an investor's risk tolerance, prominent amongst which are:
- Income: Since an investor's capacity to invest is directly dependent upon their earning capacity, their income has an impact on their risk tolerance. Investors with high income and large savings can be open to assuming a high degree of risk, whilst those with low income and savings may be risk averse.
- Investment timeline: Another key factor affecting an investor's risk tolerance is the timeline of their investment. Investors with a long term investment horizon may be willing to undertake a high degree of risk, thinking that the impact of market volatility shall be somewhat neutralised over a long period. In stark contrast, investors with a short term investment horizon may have a relatively lower risk tolerance.
- Size of the portfolio: The larger and more varied an investor's portfolio of investments, the higher their risk tolerance is likely to be. This stems from the balancing of risk across various asset classes. An investor with a smaller portfolio, on the other hand, may be risk averse.
- Availability of alternate assets: If an investor has alternate assets that add stability to their financial standing, for instance, home, car, rental income, etc., they may have a high risk tolerance when it comes to investments. An investor who has no or very few alternate assets may find it difficult to undertake high risk in their market-linked investments.
Read also - What is a riskometer?
Types of investors based on their risk tolerance
Depending upon their risk tolerance, investors can be classified into three categories, namely, aggressive investors, conservative investors, and moderate investors.
- Aggressive investors: Investors who have a high risk tolerance are termed as aggressive investors. Such investors are generally willing to assume high risk in their investment choices with the potential payoff of a high return. Aggressive investors tend to invest in high-risk and high-return assets, for instance, equity shares.
- Conservative investors: Investors who are unwilling to assume a high degree of risk in their investments are termed as conservative investors. Such investors are satisfied with restricting their return on investment as long as their risk exposure remains within the desired limits. Amongst the asset classes preferred by such investors are debentures, bonds, and government-backed securities.
- Moderate investors: Investors who wish to walk the fine line between undertaking risk and protecting their principal investments are termed as moderate investors. Such investors usually opt for a diverse and balanced portfolio so as to attain an optimal balance between risk and return. Moderate investors tend to invest in a combination of equity shares, debentures, mutual funds, money market instruments, etc. Their portfolio allocation is usually 60/40 in or 50/50.
What are the factors that influence risk tolerance?
1. Age
Age plays a significant role in determining risk tolerance. Generally, younger individuals tend to have higher risk tolerance due to their longer time horizon to recover from losses. Conversely, those approaching retirement age typically have lower risk tolerance as they have fewer years to recoup any losses.
2. Financial position
An investor's financial status is a crucial factor in determining risk tolerance. Individuals with substantial assets and minimal liabilities are more likely to tolerate higher risks as they have the financial stability to withstand short-term market fluctuations. Conversely, those with significant liabilities relative to assets may have lower risk tolerance due to limited financial flexibility.
3. Disposable income
The level of disposable income also influences risk tolerance. Investors with higher disposable income generally have greater risk tolerance, as they have the financial capacity to weather market volatilities. Future earning potential should also be considered alongside current disposable income for an accurate assessment of risk tolerance.
4. Time horizon
The duration for which an investor does not need access to the invested amount is crucial in determining risk tolerance. Those with longer time horizons typically have higher risk tolerance, as short-term market fluctuations have less impact on long-term returns. Conversely, investors with shorter time horizons exhibit lower risk tolerance, as they cannot afford to withstand significant short-term risks.
It is important to note that while these factors provide objective guidelines for assessing risk tolerance, individual preferences and circumstances may lead to deviations from these standards. For instance, an individual with ample disposable income may opt for low-risk investments despite having the capacity for higher risks.
How to determine your risk tolerance
Assessing your risk tolerance entails addressing several critical inquiries:
What are your investment goals?
Are you aiming to steadily grow your portfolio's value over time, or do you prioritise preserving your current assets and living off generated income? Each objective implies a distinct tolerance level for potential price fluctuations.
When will you require the funds?
Your investment timeframe is a pivotal factor. The closer the need for funds, the lower your risk tolerance should be. Money earmarked for a near-future home down payment differs significantly from funds accumulated for retirement, which may be years away.
How would you respond to a 18 percent portfolio loss?
Evaluating risk tolerance entails contemplating hypothetical scenarios. If your investment experienced a 18 percent decline, would you feel anxious and withdraw your funds? Or would you remain invested and perhaps consider further investment to leverage the market's downturn?
Assessment of Risk Tolerance
Financial institutions employ various methods to gauge an individual's risk tolerance, with questionnaires being a key tool. These surveys are structured to discern an individual's subjective response to diverse scenarios. For instance, a common question might inquire, "How would you react if the value of your stock holdings declined?"
X. Opt to sell
Y. Maintain current holdings
Z. Purchase additional stocks
Selecting option X reflects a conservative approach with a low appetite for risk. Option Z indicates a high level of risk tolerance and a forward-looking perspective, anticipating future price rises to profit from selling. Option Y represents a moderate risk stance. However, these assessments aren't foolproof, as individuals might choose option Z in theory but opt to sell stocks when faced with fear.
Read also - What is risk return trade off?
What is a 60/40 Portfolio?
A 60/40 portfolio is an investment portfolio with 60% allocation to equity-based instruments and 40% allocation to debt-based instruments. Considered to be an optimal portfolio for investors with moderate risk tolerance, such an investment portfolio offers a fine balance between risk and return.
Let us understand a 60/40 portfolio with the help of an example. Investor B wishes to create a 60/40 portfolio for an investment of Rs. 20,000. Their aim is to balance capital appreciation and investment protection. Therefore, they add equity stocks worth Rs. 12,000 in their investment portfolio and fixed-income government-backed securities worth Rs. 8,000. Whilst the investment in equities offers high potential for return, the investment in debt securities adds a layer of stability to the portfolio.
Financial products with high risk tolerance
Since your risk tolerance is an important factor driving your selection of investment instruments, it is pivotal to understand which financial instruments carry high risk. Equity stocks and bonds are generally considered the most high risk investment options owing to their high degree of volatility. Should you wish to invest in high risk investment instruments, you can subscribe to an Initial Public Offering (IPO) or purchase the shares of a listed company from a stock exchange.
Difference between risk tolerance and risk capacity
It is important to understand that there is a fine distinction between your risk tolerance and risk capacity. Whilst the former is a barometer of the amount of risk you are willing to expose your investments to, the latter signifies the quantum of risk you can afford to assume without jeopardising your financial objectives. Risk tolerance can, therefore, be described as a subset of risk capacity.
You can check out various mutual fund schemes and select one or more which meets your investment needs on the Bajaj Finserv Mutual Fund Platform. Browse over 1000+ listed mutual funds, compare funds, and choose the scheme based on your risk tolerance and investments goals.
You can also use our SIP calculator to compute the monthly contribution you need to make to the selected mutual fund.
