July 3, 2023
Risk tolerance is the measure of the individual investor’s willingness to tolerate loss in their investments. The investor that understands risk tolerance has a valuable tool to better guide investment choices. A familiar Wall Street adage says, “You can eat well or you can sleep well.” Simply put, If you are eating well, you are earning well from holding higher risk investments, typically stocks. Owning volatile, higher earning stocks can cause individual investors to lose sleep over their futures and when/if they might dramatically drop.
Risk tolerance plays an important role in an investor’s strategy because of the way it can determine the success of your earning potential. Having a more complete understanding of an individual’s risk tolerance allows for a plan to be created that balances the concerns of volatility with maximum earning potential.
So how does the individual investor determine the best strategy for their risk tolerance? It is more challenging to determine an investor's risk tolerance when the market is sunny. An easier way to make this more apparent is to reflect back on a more uncertain time. During the COVID lockdown, there were many uncertainties and the market was quite volatile. Recalling an investor’s reaction during this highly unstable time helps to identify their risk tolerance. If the investor responded by selling stocks in a panic, then understandably, they would have a low risk tolerance. In contrast, if the individual investor was inspired to invest more to take advantage of the potential to make more in the market sell-off, then this investor would have a higher tolerance for risk.
There are three distinct categories of risk tolerance for investors: conservative, moderate and aggressive.
An individual investor with a conservative risk tolerance makes decisions with the principal interest of the safeguarding of their capital and avoiding risk. A popular option for this focus would be a Certificate of Deposit, also known as a CD. A CD is a transaction between a financial institution that guarantees a certain rate of return in exchange for the investor leaving their capital tied into this investment for a specific period of time. Conservative investors might earn less on their investment – CD’s generally will have much lower rates of return than stocks and real estate in the long run – but are a guaranteed return that appeals to investors closer to retirement.
Shareholders that operate between conservative and aggressive are called moderate investors and have an interest in exploring both. A common example of someone with moderate risk tolerance is the 60/40 allocation spent between stocks and bond purchases. Contributions to stocks have potential to earn more but are supported by the stability of the bonds.
Individual investors with aggressive risk tolerance are shareholders who generally fill much of their portfolio with riskier assets like stocks and real estate. Having a greater understanding of the volatility of the market, they are market savvy and make choices that help them grow higher than average returns. Because they are not hindered by a timeline, or concern for short term losses, this affords them more choices. Being aggressive means being willing to accept the chance you will lose some or all of the investment.
There are tools that investors and advisors can consult to help combat investment fears. The VIX (Volatility Index) was created in 1993 and is run by the Chicago Board Options Exchange (CBOE). Used typically to measure the degree of risk an asset might be, the index is based on the option prices for the S&P 500, and takes into account how much an asset’s price moves either up or down, providing an indication of what the market expects the stocks to do over the next 30 days. Also known as the “Fear Index,” the VIX has been known to spike in response to a stock market correction, the higher the index climbs, the more volatile the individual investor can expect.
Whether an individual investor has conservative or aggressive risk tolerance, it is important for every retail shareholder to understand how the volatility of the market will affect a portfolio, making risk tolerance an important factor in any investment.
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