Risk Tolerance

What is Risk Tolerance?

8 min read

Life is not short of any actions that carry a degree of risk. Quitting jobs, changing careers, moving to different countries, and investing in the stock market are all examples of risk. Today, we will focus on the latter. Taking risks with our investments can hugely impact the quality of our lifestyle today, in the future, and for our family. Every investor has different variables in their everyday life that will affect how much risk they take. We will examine those factors and how they affect the chosen risk tolerance. There are also ways to spread risk across our investments. In the last section of this article, we will explore this. Let’s begin.

When we think of risk, the definition of magnitude differs between our investments and other actions that affect our life. That definition is different for everyone. For some, it might be riskier to change career paths than to contribute to a fund bi-weekly. For others, seeing their investments lose value daily is much more frightening. Let’s look at the different factors influencing an investor’s decision-making.
Risk Tolerance

1. Age

Age is one of the most critical factors for decision-making on any level. In general, young people tend to take many more risks. When working for a financial institution, I always advised younger (21-30) professionals and graduates to choose the riskiest portfolio possible while increasing their investment knowledge. It will be very practical in the future. The value of money is a powerful tool to use throughout life.

Usually, there are very few major expenses in the immediate future for investors under 30, making more risk tolerable; an an example would be advising clients closer to retirement to stick with more conservative investments. Therefore, it becomes important to preserve capital for daily expenses.

2. Family

Family is an important factor when making a decision. It’s important to think about children and spouses and to make the right decisions for their best interests. Once again, younger investors are less likely to have a family in their 20s. Hence, they can make riskier decisions. Families with children will usually play it safer. They want to save money for education, holidays, and a house.

3. Goals

Different investment goals have different risk strategies. For example, investors with short-term goals, such as holidays, repairs, or small purchases, should opt for relatively safe investments to preserve capital. 

However, a 20-year-old who wants to buy a property at age 35 should risk much more to reach their objective sooner and switch to safer investments.

4. Portfolio Size and Psychological Comfort

The difference in risk between an investor with a portfolio over $1M and one with 10K, In most cases, is risk tolerance. Generally speaking, investing in a smaller portfolio leads to less risk; however, this is not always the case. Investors with smaller incomes will risk less because of less capital. On the other hand, wealthier investors can take more risks.

When I worked for a financial institution, we had a questionnaire for clients who wanted to invest in mutual funds, stocks, bonds, or whatever investment vehicle was used. Many questions addressed how much an investor could tolerate losing in a set time frame. Many new and experienced investors cannot stand to see their portfolios losing value even if the funds are not necessary anytime soon.

After the questionnaire, I could place my clients into their appropriate portfolios. Each had a different risk tolerance. In the next section, we will explore them.

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Types of Risk Tolerance

Many financial institutions will offer mutual funds with varying degrees of risk. They often give them comfortable and reassuring names to make their clients feel more secure. After completing the questionnaire, they are offered an option that fills their needs. Below, we will examine the three most common portfolios and their characteristics.

1. Conservative

Investors who choose a conservative portfolio have a low tolerance risk. They prefer to see their portfolio grow slowly over time instead of seeing periods of high volatility. As a result, conservative investors tend to be closer to retirement and with a smaller portfolio balance. Often, they rely on the expertise of their financial advisor to perform trades.

A conservative portfolio comprises 10-20% bonds and 80-90% stocks. The latter are usually domestic and have a proven track record. Financial institutions are an excellent example of a stock in this portfolio. An investor can expect an average return of 3-5% annually; however, nothing is certain; these are just estimates, and the actual return fluctuates throughout the investment period.

2. Moderate/Balanced

A moderate/balanced portfolio is when investors are comfortable with more risk but want to remain balanced in their portfolio allocations. This portfolio applies to investors of all ages and social statuses.

A typical balanced portfolio holds 30-40% of bonds. The remainder is in local and domestic stocks. New sectors can be introduced. The average yearly rate of return often has a target of between 6-10%.

Risk Tolerance

3. Aggressive

The aggressive portfolio is often suggested/chosen by younger investors with more timeto hit their goals. This would be an account where the client wants to save/earn enough for a down payment on a new house. Investors who want a high level of risk choose this type of portfolio. Aggressive investors usually have a deeper knowledge of investments. They rarely use financial institutions’ investments such as mutual funds, Guaranteed Investment Certificates (GICs), or savings accounts. Instead, they have their brokerage account and perform their trades.

An aggressive portfolio can hold a wide range of stocks or a single sector, such as tech, utilities, growth, dividends, and small/mid/large-cap stocks. The portfolio contains little to no bonds. Returns and losses can both vary from year to year. With more risk, the client understands that if the market is in a downtrend, this could result in a down year or so, depending on market conditions. However, this account is also great for down markets; if used in conjunction with Dollar Cost Averaging, it can be a great way to get higher-priced equities on clearance. 

How to Spread Risk Across Investments

The saying “Don’t put all your eggs in the same basket” has been around for a long time and can be used when discussing investing. Diversification is key, spreading your allocations across different sectors and not just equities from one sector. An example would be having a mix of sectors from banking, tech, biotech, marijuana, textiles, and even some written contracts on some options to generate a premium for the account. So, long story short, please diversify.

How to Diversify

First, allocate your funds to more than one industry or type of investment. There are 11 sectors to choose from, each with different types of industries. Many asset managers create portfolios for every niche. There is something in virtually every category, from small-cap growth stocks to commodities. In all cases, proper due diligence must always be performed.

Investors should also research if the investment aligns with their risk tolerance and strategy. Every ETF and mutual fund has a fund fact or prospectus for investors to read. Take the time to go through this document before investing.

Other Investment Categories

Stocks, mutual funds, and ETFs are not the only investments available. In some cultures, investing in real estate, which is something tangible, is an excellent practice. In the last few decades, property prices have seen a huge boom. As the population keeps growing and moving into cities, the number of properties will keep increasing. Prices might also keep increasing, but there might also be a correction. It is hard to predict, but in any case, real estate is often a good option.

In some countries, being an accredited investor might open new doors. They have access to alternative investment vehicles. They come with more risk but also more reward. Once again, it is important to be knowledgeable, form DD, and research before embarking on this journey.

Final Thoughts: Risk Tolerance

To conclude, every investor has a different level of risk they are willing to undertake. Fortunately, different types of risk categories exist. Beginners can visit their local financial institutions for help, while experts can manage their investments with the help of a broker. It is important to understand how much risk to take, set up a strategy, and follow it. 

Finally, diversification is an important part of investing and reducing risk. Many investment vehicles exist, and investors should expand their knowledge of them.

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