9 Mar 2018

What is ‘Risk Tolerance’

Risk tolerance is the degree of variability in investment returns that an investor is willing to withstand. Risk tolerance is an important component in investing. You should have a realistic understanding of your ability and willingness to stomach large swings in the value of your investments; if you take on too much risk, you might panic and sell at the wrong time.

BREAKING DOWN ‘Risk Tolerance’

Assess your degree of risk tolerance by taking a risk-related questionnaire. Review historical worst-case returns for different asset classes to get an idea of how much money you would feel comfortable losing if your investments have a bad year or bad series of years. Other factors affecting risk tolerance are the time horizon you have to invest, your future earning capacity, and the presence of other assets such as a home, pension, Social Security or an inheritance. In general, you can take greater risk with investable assets when you have other, more stable sources of funds available.

Aggressive Risk Tolerance

Aggressive investors tend to be market-savvy. A deep understanding of securities and their propensities allows such individuals and institutional investors to purchase highly volatile instruments, such as small company stocks that can plummet to zero or options contracts that can expire worthless.

While maintaining a base of riskless securities, aggressive investors reach for maximum returns with maximum risk. For example, a favorite hedge fund bet in 2014, SunEdison, a solar power provider, was estimated to be worth $32 per share by Greenlight Capital’s David Einhorn, who took a $480 million stake in the company. The stock, after being exposed for duplicitous accounting practices, sits at 14 cents per share on July 1, 2016.

Moderate Risk Tolerance

Moderate investors accept some risk to principal but adopt a balanced approach with intermediate term time horizons of five to 10 years. Combining large-company mutual funds with less volatile bonds and riskless securities, moderate investors often pursue a 50/50 structure. A typical strategy might involve investing half of the portfolio in a dividend-paying, growth fund such as the T. Rowe Price Equity Index 500 fund, which holds average risk and has returned 7.19% annually on average through the 10 years ending July 1, 2016.

Conservative Risk Tolerance

Conservative investors are willing to accept little to no volatility in their investment portfolios. Often, retirees who have spent decades building a nest egg are unwilling to allow any type of risk to their principal. A conservative investor targets vehicles that are guaranteed and highly liquid. Risk-averse individuals opt for bank certificates of deposit (CDs), money markets, or U.S. Treasuries for income and preservation of capital. The current yield on a 10-year Treasury bond as of July 1, 2016, stands at 1.46%, while the Vanguard Prime Money Market Fund offers a 0.45% yield.

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