Understanding Risk Tolerance: Balancing Risks And Rewards In Investments

There is no doubt that every investment comes with a certain degree of risk of default. Therefore, investors should always consider the amount of risk they are comfortable with or can tolerate when investing in any asset class.

What is Risk Tolerance?

Simply put, it is the amount of money an investor is comfortable to lose when making an investment. Therefore, anyone willing to lose only a small part of their investment has a lower risk tolerance, while anyone open to losing a larger amount of their investment in the hope of higher gains has a high appetite for risk.

Understanding one's risk tolerance is vital when looking to invest or plan an investment portfolio. For instance, people with a low appetite for risk often settle on less volatile investments.

Types Of Risk Takers

Investors are broadly classified into three categories based on their investment strategies, determined by their risk tolerance levels. 

Aggressive Investors

These are investors with a high-risk tolerance and are likely to be well-versed in the market and, therefore, ready to take greater risks. Such investors are usually unperturbed by negative changes in their portfolio, either due to a higher safety net or the ability to sustain investment for a longer period of time in anticipation of eventual returns. While larger amounts of risk create the possibility of large returns as well, such investors also stand a high chance of losing all or significant parts of their capital.

Moderate Investors

These are investors that resort to moderate investment strategies. They are less risk tolerant compared to aggressive investors. Therefore, when the market is doing well, they make slightly lower returns than aggressive investors. Similarly, in case of a downturn, their losses can be considerably lower.

Conservative Investors

Just as the name implies, conservative investors are extremely cautious and have limited risk tolerance. Therefore, they avoid risky or volatile investments as they value protecting capital instead of generating profits. While they incur the least losses, their strategies also limit their profits even under attractive market conditions.

Factors Influencing Risk Appetite

Investors Age

It's common for younger investors to have a high-risk tolerance. Young people can take greater risks as they have the capacity and time to make more money even if they incur significant losses in one investment. In contrast, older investors have a lower risk appetite as they need to ensure their savings are available through their retirement. Older investors also generally have more financial responsibilities and hence are likely to be more conservative.

Investment Capital

The higher the amount of capital up for investment, the more willing an investor would be to take in more risk. More capital offers a layer of protection, allowing investors to place bold and larger trades in the market. Therefore, an investor with a portfolio running into crores of rupees will always be ready to take more risks than an individual with a portfolio with thousands.

Higher Income Stability

Investors with high stable incomes are always ready to experiment with investments as their financial position is more than secure. Therefore, they tend to have higher risk tolerance. In contrast, an investor with a low, unstable income will have a low-risk tolerance, as losing any amount could be detrimental to their financial goals.

Investment Objectives

Investors who want to accumulate significant returns over a short period will always have a higher risk tolerance. As a result, they tend to risk more in an attempt to generate greater returns. In contrast, conservative investors with a low appetite for risk will always invest cautiously and will be contended with accumulating small returns over a long period.

How To Manage Risk Effectively

The best way to manage risk is to gauge one’s risk tolerance before settling on any investment opportunity. Knowing the amount of loss one can tolerate makes it much easier to make informed and calculated decisions.

While risk is a double-edged sword, it is essential to invest only what one can afford to lose. While risking more increases the prospects of earning more, it also increases the risk of incurring significant losses in a downturn.

Some other ways to manage risks are:

• Diversification
  Diversifying an investment portfolio helps spread risk across various asset classes. Consequently, whenever one asset is down another asset is able to offset the losses.  The idea is to spread risk across various asset classes.
• Regular Assessment and Rebalancing of Portfolio
  Regular assessment is essential to keep track of how various assets are doing.  The assessment can help note assets that are not doing well, therefore, reducing exposure and increasing exposure on assets that are doing well.

Conclusion

Every investment has its fair share of risks. Therefore, any investor should be aware of the amount of risk they can tolerate without their portfolio or capital being wiped clean. A high-risk investment offers the potential for higher returns yet it is not guaranteed.

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