Risk tolerance is an important component of investment decisions and investment. So, what is risk tolerance and what factors are affected?
Before you start finding the best investment for yourself on the road to achieving your financial goals, it is wise to understand your risk tolerance and learn your risk profile.
Otherwise, investing without understanding the maximum risk level you may take in your investments may endanger your financial goals.
What is Risk Tolerance?
Risk tolerance or risk profile is a measure of the amount of risks in the market and the extent to which the investor can tolerate volatility (ups and downs) for their investments.
In other words, risk tolerance refers to the capacity of an investor to bear the risk of any investment or investment. Risk tolerance is crucial for the investor to determine the best investment strategy and to find out which investments are suitable for him.
Risk tolerance, usually calculated through a calculator or simple tests, divides investors into three classes: Aggressive, Balanced, or Retention.
How is Risk Tolerance Measured and Why is it Important?
A risk tolerance test reveals investor attitudes towards positive or negative situations by asking various questions about different market scenarios. In order for the test to be most accurate, investors should answer the questions with the most precise responses to possible scenarios.
Let’s look at an example question that always takes place in risk tolerance tests and how possible answers can determine investor profiles:
What would you do if the stock market drops 20 percent during the year?
A) I do nothing
B) I wait a few months to make a decision
C) Buy my stocks immediately
When asked such a question, probably an aggressive investor would answer ‘A’, a balanced investor would answer ‘B’ and a conservative investor would answer ‘C’.
The aim of similar tests is to help the investor create an investment portfolio that will be comfortable for a long time and not be under stress. For example, the abrupt abandonment of investment strategies in the stock market is often not the right response.
Therefore, risk tolerance tests help the investor with an early aim by predicting the weaknesses and strengths of the investors in possible investments and market scenarios.
What are the Factors Affecting Risk Tolerance?
Abstract elements such as investor’s experiences, talents and goals and financial concrete elements affect risk tolerance.
For example, the income of the investor, the earning potential of current investments, assets such as real estate, a legacy to remain or the wealth it possesses are among the factors that affect the risk tolerance.
For example, the higher the investor’s earning potential, the higher the risk it often takes.
The maturity of the investments is also related to the risk tolerance. For example, achieving the targeted earnings in a shorter period of time, even if a problem arises, the investor’s belief that it can overcome it plays an important role in determining risk tolerance.
In addition, inheritance and the possibility of compensation for possible losses are also at risk tolerance. For example, if an investor expects a large legacy, it may be more likely for him to take risks and stretch risk tolerance. In addition, there are different criteria for the investor to have sufficient time to compensate for their losses (for a younger individual) or to have a diversified investment portfolio by professional diversification.
Risk Tolerance and Risk Capacity Distinction
Another aspect of risk tolerance is the risk capacity that defines the level of risk you are taking. This is slightly different from the risk you want to take.
That is, you can have an aggressive profile and feel comfortable with a high-risk portfolio, but if you’re not a younger person than before, or if your financial priorities have changed (such as retirement, education costs for children), a high-risk investment portfolio might not be appropriate for you.
Therefore, regardless of your risk tolerance, it is ideal to periodically review your risk capacity as your financial goals may change over time.