Knowing Your Risk Tolerance While Making Investments
When you start your investment journey, it becomes clear that no investment is 100% safe. Every investor needs to assume some risk while choosing different classes of investments. Any rational individual would want to get the highest possible ROI (Return on Investment) on an asset while assuming the lowest possible risk. However, there is a trade-off that you need to consider, wherein the expected volatility of returns increases with higher returns. Here, risk tolerance is important because anticipation of a higher return leads to higher risks.
Being overly aggressive with your portfolio can lead to higher returns during favourable market conditions. However, it can also result in negative returns during unfavourable times. Hence, it is critical to understand and acknowledge your risk appetite and tolerance when making investments.
Let’s understand the concept of risk tolerance, its categories, the factors affecting it, and how it can help make smarter investment decisions.
What Is Risk Tolerance?
Before understanding the concept of risk tolerance, let’s evaluate what ‘risk’ is in investing. Simply put, it refers to the expected fluctuation an investor expects from the investment returns. Investment risk can arise due to market conditions, business cycles, government policies, and liquidity issues. Due to such external factors, there is always a chance of receiving lower (or higher) returns than anticipated.
Risk tolerance or appetite is the amount of uncertainty or potential loss an investor is willing to accept while making an investment decision. It depends on various factors, such as the investor's age, financial goals, market experience, and the state of the economy.
Risk assessment is critical to having a balanced and diversified portfolio that can help attain an individual's long-term goals. Without knowing your risk tolerance levels, it is easy to make a few reckless financial decisions that can eat away your corpus. At the same time, you can also act timid in favourable market conditions, losing on excellent investment opportunities.
Investing without considering risk tolerance can prove to be fatal. An investor must know how to react when the value of investments falls. Many investors flee the market and sell low in the process. At the same time, a market decline can be a great time to buy. Therefore, ascertaining risk tolerance helps in making informed decisions and not making hasty, wrongful decisions.
Types Of Risk Tolerance
Based on the investment risk appetite and tolerance, investors can be broadly classified into three categories:
- Aggressive: As the name suggests, an aggressive investor would accept substantial market fluctuations while pursuing higher returns.
- Moderate: Moderate investors have a more diversified approach where they try to balance growth and stability.
- Conservative: These investors aim to preserve the principal amount and avoid volatility in returns.
Here is a table differentiating these investors based on their risk tolerance:
Aspect | Aggressive Investors | Moderate Investors | Conservative Investors |
Primary Aim | Maximising long-term returns | Balanced growth and stability | Capital preservation and steady income |
Risk Acceptance | High (comfortable with volatility) | Moderate (willing to accept some volatility) | Low (prefers minimal fluctuations) |
Preferred Investments | High-growth equities, small-cap stocks, sector-specific mutual funds | A mix of equities (large-cap, index funds), balanced funds, fixed-income securities like corporate bonds | Fixed deposits, government bonds, and other fixed-income securities rated ‘A’ or above
|
Anticipated ROI | Potentially high (15%+ annually, but with larger drawdowns) | Moderate (8–10% annually, moderate drawdowns) | Lower (5–7% annually, minimal drawdowns) |
Emotional Resilience | Strong (comfortable with 30–40% dips) | Moderate (tolerates modest declines) | Lower (prefers stability over high returns) |
Example Of Risk Tolerance And Impact On Portfolio
Let us consider an example of three investors with a different level of risk tolerance:
Details: Aavesh, Madhav and Nirmal are three investors with aggressive, moderate, and conservative risk tolerance respectively. They invested INR 10 lakhs in different securities as per their risk appetite. The following table shows the performance of the portfolios along with overall volatility.
Name of Investor | Aavesh | Madhav | Nirmal |
Risk Tolerance | Aggressive | Moderate | Conservative |
Invested Assets | Sector Specific Mutual Fund (Infrastructure) | Nifty 50 Index Fund (50%), Corporate Bond (30%), FD (20%) | FD and Corporate Bonds |
Initial Principal Investment | INR 10 lakhs | INR 10 lakhs | INR 10 lakhs |
10-Year Tenure Beginning With | 2012 | 2012 | 2012 |
Value | At year-end | At year-end | At year-end |
2013 | 10,24,000 | 10,76,000 | 10,85,000 |
2014 | 16,40,448 | 12,90,662 | 11,77,225 |
2015 | 16,65,054 | 13,19,056 | 12,77,289 |
2016 | 16,60,059 | 13,94,902 | 13,85,858 |
2017 | 24,23,686 | 16,53,656 | 15,03,656 |
2018 | 22,32,215 | 17,49,568 | 16,31,467 |
2019 | 24,68,830 | 19,29,774 | 17,70,142 |
2020 | 21,92,321 | 21,55,557 | 19,20,604 |
2021 | 23,54,553 | 25,14,458 | 20,83,855 |
2022 | 31,15,074 | 26,75,383 | 22,60,983 |
Risk (Standard Deviation of Returns) | 22.71% | 5.76% | - |
Commentary on Portfolio Management of Investors
- Aavesh has the highest return, but he assumes the highest risk.
- The entry and exit in a portfolio can be the deciding factor, as an aggressive portfolio provides negative returns in a couple of instances.
- In the above example, Madhav has been able to earn steady returns with marginal risk. His risk appetite is higher than Nirmal with marginal risk. He has earned better returns than him, at the same time took lower risk than Aavesh.
- The example of Madhav suggested that if you have a specific life goal, such as a pension or retirement, putting your money in a diversified portfolio is critical.
- The returns suggested are not indicators of future performance.
- The calculations assume a constant return on bonds and fixed deposits throughout the 10-year period.
Factors That Influence Risk Tolerance
Your risk tolerance depends on a variety of factors explained in the following table:
Factor | Details |
Timelines | Longer horizons often allow more risk; shorter horizons require safer choices. |
Goals | Specific financial objectives influence whether you opt for growth or stability. |
Age | Younger investors can typically afford higher risk; older investors often prioritise preservation. |
Portfolio Size | Larger portfolios may tolerate more volatility; smaller ones may need caution. |
Investor’s Comfort Level | Personal emotions and stress response dictate how much uncertainty is tolerable. |
Investment Experience | The experience that an investor has helps him in assessing the level of risk he can take. |
Disposable Income | Higher the disposable income, higher the risk tolerance will be. |
How Risk Can Help Shape Your Investment Decisions
You should know your risk tolerance to make the correct investment decision. It becomes easier to navigate through market volatility when you are sure about your risk appetite and acknowledge that fluctuations are part of an investment journey. With time, your circumstances, goals, and market conditions evolve. Based on that, you can shift from a more aggressive to a moderate risk strategy (or vice versa).
To sum up, self-awareness about risk tolerance can be the cornerstone of the investment process. It promotes thoughtful, deliberate investing rather than reacting to short-term market turbulence. To know more about risk - return spectrum and portfolio diversification with fixed income opportunities, sign-up on Grip Invest today.
Frequently Asked Questions On Risk Tolerance
1. What is the risk tolerance score in investing?
A risk tolerance score is a numerical measure used to determine how much market volatility and potential loss an investor is willing to accept.
2. How do I know my risk profile?
You can understand your risk profile by evaluating factors like your financial goals, investment horizon, current assets, and personal comfort with potential losses.
3. What is an example of risk tolerance?
An example of risk tolerance is an investor who comfortably accepts short-term fluctuations in stock prices for the potential of higher long-term gains.
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