Words for the Week: #4
Risk Tolerance by definition in the Financial Services industry is: The degree of risk that an investor is willing to endure given the volatility in the value of an investment. An important component in investing, risk tolerance often determines the type and amount of investments that an individual chooses.
Greater risk tolerance is often synonymous with investment in stocks, equity funds, and exchange-traded funds (ETFs), while lower risk tolerance is often associated with the purchase of bonds, bond funds, and income funds.. All investments involve some degree of risk and knowing their risk tolerance level helps investors plan their entire portfolio, determining how they invest. Based on how much risk they can tolerate, investors are classified as aggressive, moderate, and conservative.
One factor that affects risk tolerance includes the time horizon for an investor. Having a financial goal with a long time horizon, an investor may have greater returns by carefully investing in higher-risk assets, such as stocks. Conversely, lower-risk cash investments may be appropriate for short-term financial goals.
An investor's future earning capacity, and the presence of other assets such as a home, pension, Social Security, or an inheritance affect risk tolerance. An investor can take greater risk with investable assets when they have other, more stable sources of funds available. Additionally, investors with a larger portfolio may be more tolerant to risk, as the percentage of loss is much less in a larger portfolio when compared to a smaller portfolio.
Aggressive Risk Tolerance
An aggressive investor, or one with a high-risk tolerance, is willing to risk losing money to get potentially better results.1 Aggressive investors tend to be market-savvy with an understanding of the volatility of securities and follow strategies for achieving higher than average returns.
Their investments emphasize capital appreciation rather than income or preserving their principal investment. This investor's asset allocation commonly includes stocks and little or no allocation to bonds or cash.
Moderate Risk Tolerance
Moderate investors want to grow their money without losing too much. Their goal is to weigh opportunities and risks and this investor's aptitude for risk is sometimes described as a “balanced” strategy. Commonly, moderate investors develop a portfolio that includes a mixture of stocks and bonds, perhaps as a 50/50 or 60/40 structure.
Conservative Risk Tolerance
Conservative investors are willing to accept little to no volatility in their investment portfolios. Retirees or those close to retirement age are often included in this category as they may be unwilling to risk a loss to their principal investment and have a short-term investment strategy. A conservative investor targets vehicles that are guaranteed and highly liquid. Risk-averse individuals commonly opt for bank (CDs), money markets, or U.S. Treasuries for income and preservation of capital.
Risk tolerance can vary from one individual to another. Also a person can have a Risk Tolerance that varies depending on the type of account, market volatility, and current life situations. Over time one may have more than one Risk Tolerance dependent on a few different factors. Financial Advisors spend a great deal of time evaluating clients Risk Tolerance. Estimating an accurate Risk Tolerance is essential to building an effective portfolio. The accurate evaluation enhances communications and performance.
Please contact us for a conversation about your Risk Tolerance and to assist us and yourself with an evaluation of your individual personal Risk Tolerance. It is important. Usually painless. and a lot more enjoyable conversation than "The Talk". We look forward to communicating with you