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What is Risk Tolerance? Research Team | Posted On Tuesday, March 24,2009, 07:28 PM

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What is Risk Tolerance?



Risk Tolerance

The matter of risk is always surrounded by two general questions and these questions are interchangeable. The first important question is how much risk can you handle psychologically? And the second question is how much risk should you take on?

The answer to Question 1 is not always alike to the answer to Question 2, even though some financial advisors act like it is alike. Question 1 is about risk tolerance that is how comfortable we are watching our investment portfolios take a punch. But, just because a financial advisor wants to take a risk, that doesn't mean he or she should take the risk.

In such case Question 2 comes in. Regrettably, risk tolerance alone is often used as the key factor when determining the asset allocation for a portfolio. A blend of three factors should be considered when creating a long-term investment strategy; they are risk tolerance, the financial capacity for risk and the optimal risk.

What is risk tolerance in risk management?

Risk tolerance is a measure of your willingness to admit higher risk or instability in exchange for higher potential returns. Those with high tolerance are aggressive investors and are willing to accept losing their capital in hunt for higher returns. Those with a low tolerance, also called risk averse, these are more conservative investors who are more concerned with capital preservation. Neither one is "most excellent" option to choose.

A risk tolerant investor will practice higher potential reward investments even when there is a greater potential for a loss. A risk tolerant individual may not sell his stocks in a temporary market correction, while a risk averse person might fear and sell at the wrong time. On the other end, a risk tolerant person could be seeking out high-risk investments, even if they add tiny to his or her portfolio.

Your risk tolerance is a measure of how much risk you can handle, but that need not be the same as the appropriate amount of risk you should take. That makes us to think about the second risk assessment that should be done.

Capacity to Accept Risk

When applying the perception of risk to investing, there are really two types of risk related attributes that are fairly distinct. One is psychological attribute known as risk tolerance which is already mentioned above and the other type of risk deals with financial ability or capacity to tolerate risk.

Financial risk capacity can be calculated in many different ways, including time horizon, liquidity, wealth and income. People, who have a high liquidity requirement that is they could need access to their money at any time, are embarrassed to how much risk they can take. They are forced to stay away from investments that might be potentially productive because they do not offer the required liquidity. In the long term prospect, instability of the markets is dampened, and returns will move toward long-term historical averages. The greater the time horizon, the greater will be the capacity for risk. This is due to the short-term volatility of the markets loses its significance.

The people with high income and high wealth can make higher risk investments because they have funds coming in apart from of the market conditions. Likewise young investors, with limited funds to invest, have the capacity for high risk since they have longer time horizons. Any short term drops can be waited out, lowering the chance of having to withdraw before the markets leap back. This shows us to the third consideration which is the optimal risk of the portfolio.

Optimal Risk

It is reasonably different from risk tolerance, and risk capacity, is optimal risk. The above mentioned types apply to the individual investor, but optimal risk applies to the construction of risk-efficient portfolios. Optimal risk of a portfolio comes from modern portfolio theory. Central to the theory is that investors are trying minimize variance (risk) at the same time they try to maximize their returns.

In this theory there is an ideal arrangement of asset classes. This is the position where adding another unit of risk will provide mainly marginal return. Showing it in other way, it is the point you will get the most hit (return) for your money (risk). This point is found on the curve of the efficient frontier, this can be clearly observed in the below diagram.

The efficient frontier is dogged through an optimization that analyzes various combinations of different asset classes. The efficient frontier is based on historical relationship between risk and return and the correlations between the various asset classes.

As through any calculation, the information going into the model might be inadequate; this could result in a faulty result. Besides, as it's a historically-based calculation, it will not essentially hold in the future. There is no certification that the optimal mix for the past 10 years will be the same as the optimal mix for the next 10 years

How Much Risk Should You Take?

For the majority investors, their risk tolerance, their financial capacity for risk and the optimal portfolio risk will be associated closely. In other way, they're close to each other on the efficient frontier. Yet for some investors the balance is out of position.

A lot of investors meet with a new financial advisor they will be asked to fill out a risk tolerance questionnaire and there are three problems with this approach :

  • The questions are all hypothetical - In real life investors frequently act in a different way than they think they will act when faced with hard times. Being asked how you'd feel if your portfolio drops 30% is much different than actually watching it happens.
  • A risk-tolerance-based portfolio may not meet financialobjectives- A portfolio that meet risk tolerance objectives, could be unsuccessful to meet financial objectives. For example, a risk averse investor might end up with a portfolio that won't ultimately be significance enough to sustain him or her during retirement.
  • Risk tolerance may not align with financial reality - What you can psychologically tolerate might be greater than your financial capacity to do so. For example, an investor who trades futures can psychologically hold the unpredictability, but a large think that goes wrong could wipe him out financially.

First and foremost, the capacity for financial risk should govern. An investor should never take more risk than he or she has the capacity to suck up. Take for an instance if you needed all your money next week, you would not invest all of it in the stock market today. If your current finances can not hold a temporary slow down, then risk should be avoided. Investors should struggle for the optimal risk point where there is a good tradeoff between risk and reward.

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