What is risk tolerance and why is it important to investors? As an investor you’ve probably been asked this question by yourself, or your financial advisor. It’s not an easy question to answer and not a question that can be answered with one word or a quick sentence.
Risk tolerance is simply a particular investor’s appetite for risk. Some investors have little appetite for risk and their stomach churns when they think about losing money in the market. Generally these investors are considered risk averse or risk intolerant.
Other investors aren’t really concerned about the ups and downs of the market and are willing to accept these market gyrations in or to receive the benefit of potentially higher returns. This is called the risk/return trade-off. In order for investors to receive higher returns they generally have to be willing to accept more risk for those returns. In other words, these investors are risk tolerant.
So why is this concept important for investors? It’s important for a number of reasons. The first is that it helps the investor and their advisor properly line up the correct investment portfolio for that particular investor. A risk averse investor will generally be more at ease in a low-risk portfolio with few, if any equities, more exposure to high-quality bonds and cash. A risk tolerant investor would be more tolerant of risk – such as more exposure to equities, and riskier assets.
But determining what an investor’s appetite for risk isn’t that easy. There are a number of risk tolerance questionnaires used by various companies and professionals to help investors narrow down their true tolerance. This is hard to do depending on the day – literally!
The reason why is because on any given day the market could be way up, way down, or flat. Someone who is really risk averse may feel risk tolerant in a bull market (isn’t everybody?), but that same person will run for the antacids the second the market drops; which leads to this point:
Investors’ real appetite for risk appears in bear markets.
So what can investors do? Find a professional that asks a lot of questions and takes the time to get to know you. Yes, a risk tolerance questionnaire can be used and is a good thing, but the questionnaire should be only a piece of the conversation. Investors can ask themselves questions too.
Imagine you have $100,000 invested and in two weeks it grows to $150,000. How do you feel? In another two weeks it plummets to $75,000. Now how do you feel?
You answer will determine nodding in expectation or running to the medicine cabinet.