Every Investor needs to understand why risk tolerance in investing matters much. It is one factor that needs proper consideration before planning on building investment.
This is because you may be taking the wrong approach if you start investing right away without analyzing certain factors. For instance, determining your comfort level, which simply means the level of attitude you will likely display when the risk occurs.
Again, how you react towards other situations that surround your investment goals. For instance how you are willing to push ahead during market fluctuations.
What is Risk Tolerance in investing?
Risk tolerance is the height of loss an investor is willing to accept while experiencing volatility in investment. Thus, an investor’s level of risk tolerance may be high or low.
High-risk tolerance is the willingness to accept losing some money to gain high income, even if you should start again.
Low-risk tolerance is the unwillingness or reluctance to accept losing some money for fear of starting over.
Therefore an investor can either be willing to accept a decline in the invested capital by reinvesting to attain gain. Or not willing to take the loss by declining to reinvest.
Why Risk Tolerance in Investing Matters
There are a handful of reasons why risk tolerance in investing is important. One major motive is that investors can ascertain how willing and ready they are to accept investment risk. Aside from this fact, other reasons are:
1. It gives the investor financial security
When making investment decisions, investors who understand their risk tolerance level will likely prioritize risk when making plans. As they understand too well the level of risk they can take, it will enable them to avoid excessive loss.
Especially when they know that such loss will endanger their financial health, thus with this investment decision, an investor may be able to avert risk and succeed in achieving a sustainable economic life.
2. Long-term investment goals
Risk tolerance encourages investors to pursue long-term investment goals. This strategy mostly favors investors with a high level of risk tolerance. This is because they could still maintain their investment even during market fluctuation.
They understand that within the long period, they are likely to recover back from the effect of fluctuation. Thus with this knowledge of long-term strategy investors may avoid making a decision that involves short-term investing and market fluctuation
3. It helps in decision making
Investment strategies are formulated to help investors in decision-making. Investors who understand their risk tolerance through decision-making will choose an investment strategy that aligns with their risk level.
Through decision-making, they will also invest in assets that will balance their potential return and risk acceptance.
4. Portfolio diversification
When investors understand their risk tolerance too well and have a good knowledge of building a portfolio of assets. They would be able to diversify assets according to the level of risk they are willing to accept.
Factors that influence investors’ risk tolerance
Risks can be inevitable but no investor ever prays to witness one. However, while making investments certain inevitable factors can trigger you to react when losses occur.
1. Your investment goals
Your persistence and determination to achieve your investment objectives can influence your risk tolerance. For instance, an investor investing specifically for retirement will keep striving until goals are achieved. Such investors may rely on long-term strategy and in the cause of this exercise a high level of risk tolerance.
2. Your level of financial resource
Your level of income flow, assets in possession, and financial responsibilities can trigger your reactions to losses or gains. A person of high net worth or stable financial resources can display an aggressive level toward loss of investment.
This person will be willing to invest more and at the same time learn from experience. While a person with a limited source of funds may have a low level of risk tolerance.
3. Your level of expertise
Your understanding of personal finance is very crucial and how experienced you are in managing financial assets. It also goes on to demand your understanding of diversification as a means of reducing risk.
An investor who possesses enough knowledge and dealings in investment may possess a high level of risk tolerance. With adequate knowledge, it will be easy for the investor to manipulate things and get back on track.
On the other hand, venturing into an investment without enough knowledge can make you give up easily when you experience losses.
4. Fear of future circumstance
Your positive or negative reactions to an unexpected occurrence, if you express fear or confidence it speaks more of your risk tolerance level.
A person who displays much anxiety over what will happen at the occurrence of loss may have a low level of risk tolerance. While someone who possesses confidence can bear the risk and move ahead.
Types of risk Tolerance
While some investors are ready to risk it and make a huge profit, others are unwilling to do so. It is essential here for each one to understand their levels of risk reaction.
This knowledge can help the investor plan properly when collecting asset classes. Thus, we have aggressive risk tolerance, moderate risk tolerance, and a conservative level of risk tolerance.
Here you are willing to take risks but to an extent. You can lose money to make a profit but not more than you are willing to lose.
Investors with this level of risk tolerance are viewed as not having many funds to commit. Thus, when they commit the much as they can afford, they always hope for the best.
When a risk occurs, they tend to endure for a shorter time but may not commit further funds.
This level of risk tolerance shows investors are willing and ready to take risks at all odds. They can handle market volatility because they are willing to keep pushing regardless of the outcome.
Investors with this level of risk tolerance usually gain huge income. They understand their area of investment risk and are ready to bear the consequence.
Investors at this level tend to have enough funds to commit to investments.
Investors with a conservative level of risk tolerance usually exhibit carefulness and safety when building investments.
They would get to any length in making sure they avoid or minimize risk. They would rather practice before applying than do it right away and meet failure.
They tend to be more careful in avoiding risk than taking every odd to gain profit. Investors in this category are mainly pensioners and salary earners.
High and low, risk investments
Some assets are considered to be high-risk investments, while others are low-risk. Understanding them could help investors understand which one matches their comfort level.
With this, Investors could be able to discern which assets to invest in and what asset classes to collect when building a portfolio.
Most investors especially beginners may find it difficult to detect these assets and where the risk lies. Therefore it is important to understand what assets are high and which are low for investment.
High-risk assets or investment are considered as one that has a greater percentage of losses to the amount of fund contributed. It can also have more chances of underperformance as compared to low-risk assets.
Examples of such investments are; Stocks, Options, High yield bonds, Crypto-assets, and Real estate. However, regardless of the high chances of loss these investments also can yield greater returns.
On the other hand, low-risk investments are considered as those investments that have minimum chances of loss. It also has less revenue return. Examples of low-risk investments are; corporate bonds, Preferred stocks, Money market funds, Index funds, Exchange-traded funds, and more.
How you can decide your risk tolerance in investment
As an investor, you must decide your level of risk tolerance. You can do this before embarking on your investment goals. Below are some reflections that can help you understand your level and willingness to accept loss.
1. What are your financial goals?
You need to do some self-examination by accessing your investment objectives; your first question is to ask yourself if you are planning on a long-term investment.
If so, you need to know that long-term investing can help you overcome risk, but you only need patience. If you are planning for the short-term then you must have a way to minimize risk.
What are you investing for? Is it for retirement, to solve immediate needs and emergencies or do you just want to accumulate wealth and build a legacy? The more you underrate your goals the lower your risk tolerance may be.
2. How knowledgeable are you
If you are a beginner investor and have little knowledge of your style of investment your risk tolerance might be low. Although this might be temporary because as you gain more experience, you will also increase your risk tolerance.
Therefore, a good valuation of your knowledge about your style of investment could help you decide what level you possess. If you understand the financial market and the different financial assets too well you stand a chance to accept risk.
3. Evaluate your financial capacity
Have you thought about your financial status? Maybe you need to make investments to expand your income capacity but you just own a limited fund. Can your income, assets, liquidity, and liability stand a loss in investment? Then if not, this might lower your risk tolerance.
4. Are you willing to diversify?
One of the reasons for diversification is to minimize risk. Your self-assessment should include if you are willing to diversify your investments across different asset classes and sectors. A positive accession will indicate a high level of risk tolerance. While a negative will speak otherwise.
By understanding why risk tolerance in investment matters, you could be able to develop a personalized investment strategy. One that works with your financial objectives and you will be able to improve on your emotional comfort.
Investors need to be aware that every investment is subject to some level of risk. Losing your initial capital does not make you a failure but gives you more insight into how to stand steadfast.
Even the professionals in investment are likely to experience losses. The difference is the level of risk tolerance they show compared to a beginner investor. Another difference is the fund each committed towards the investment.