Imagine going on a hike and finding two trails to reach the same peak- one with a gradual slope that takes 5 hours to cover, the other that is difficult to climb but needs less time. The inherent risk of hiking exists, but the choice here also depends on your ability to take the riskier route and need to reach the peak early. A similar scenario can be seen in investments. Whether you opt for the riskier trail (high-risk investments) or the safer trail (low-risk investments) depends on your level of risk tolerance. What is it, and how does it affect your portfolio? Let’s understand.
What is risk tolerance?
Risk tolerance, in simple words, is your ability to handle the risks of the financial markets without making emotion-driven, impulsive decisions. It shows how much market fluctuation and uncertainty you can endure while seeking gains.
Knowing your risk tolerance helps match your trading or investment strategies with your comfort level. This understanding enables you to make rational decisions based on your risk preferences, like adding short- or long-term investment stocks to the portfolio. Having a high-risk tolerance means you’re comfortable with significant market volatility and are willing to invest in assets with higher potential rewards, like short-term trading or aggressive investments. On the other hand, a low-risk tolerance means you prefer stable investments, focusing on capital preservation over rapid gains.
Risk tolerance is often used interchangeably with risk capacity. Your risk capacity, or how much investment risk you can handle, depends on your financial situation. Unlike risk tolerance, which may stay constant throughout your life, risk capacity is flexible. It changes based on your personal and financial goals and the timeline for achieving them.
Types of investors based on risk tolerance:
- Aggressive:
Aggressive investors are market-savvy and take big risks. They often see large portfolio fluctuations. These investors favor volatile assets like equities. While they gain high returns in good markets, they also face significant losses in downturns. However, they don’t panic during market crises as they are accustomed to daily fluctuations.
- Moderate:
Moderate investors accept comparatively lower risk but set limits on potential losses. They balance their investments between risky and safe assets, the classic combination followed by most being the 40:60 asset allocation between bonds and stocks. This approach yields lower returns than aggressive investors in good markets, but it also minimizes losses during market downturns.
- Conservative:
Conservative investors take minimal risks. They avoid risky investments and choose the safer options. Their priority is to avoid losses rather than seek gains. So, their portfolio is inclined towards secure asset classes like fixed deposits and public provident funds, where their capital is protected.
How do you know your risk tolerance?
Determining your risk tolerance involves answering key questions:
- What is your investment objective? Are you investing regularly to grow your wealth, or do you already have a substantial amount and want to preserve it while living off the income? Each goal affects your tolerance for downside risk.
- When do you need the funds? Your time horizon is crucial. If you need the money soon, your risk tolerance will be lower. Money for a home down payment next year differs from retirement funds needed years away.
- What would you do if your portfolio lost 20% this year? Think about your emotional resilience. If your investment lost 20%, would you panic and withdraw your funds, or would you keep it invested and consider adding more to capitalize on the discount?
- Your understanding of investments and past experiences shape your risk tolerance. As a newbie, you might be cautious but take more risks with experience.
Let’s understand it another way: Remember March 2020? The market crashed, unemployment spiked, and the world faced massive uncertainty due to COVID-19. What was your course of action back then? Did you hold onto your investments? If you sold stocks in panic, your risk tolerance was low. But if you invested more during the sell-off, your high-risk tolerance paid off as the market hit record highs in 2021.
How does identifying risk tolerance affect your portfolio?
Let’s understand the effects with the help of a hypothetical example-
| Risk Preference | Composition | Average Annual Return | Best 12-Month Return | Worst 12-Month Return |
| Conservative | 20% Stocks, 10% International Stocks, 50% Bonds, 20% Short-term Investments | 6% | 30% | -10% |
| Balanced | 40% Stocks, 20% International Stocks, 30% Bonds, 10% Short-term Investments | 7.50% | 60% | -30% |
| Growth | 50% Stocks, 25% International Stocks, 20% Bonds, 5% Short-term Investments | 9% | 90% | -40% |
| Aggressive | 60% Stocks, 30% International Stocks, 10% Bonds | 10% | 130% | -60% |
These varied results here show that taking extra investment risks can offer a bigger payoff than playing it safe. However, more aggressive choices will also test your risk tolerance. For example, the growth portfolio illustrated here would have averaged nearly 9% annual returns, less than the 10% return of the aggressive portfolio, over the same period. However, for someone with lower risk tolerance, the benefit of comparatively less volatility is more important.
Adding more fixed-income investments to your portfolio can lower long-term return expectations but significantly reduce market volatility. Many investors find this trade-off worthwhile, especially as they age and become more risk-averse. For instance, if you are to retire within the next three years, your approach might shift to a balanced or conservative portfolio. But, if the retirement is within 15 years, you can go for bigger payouts through growth or aggressive portfolios.
Conclusion:
Understanding your risk tolerance and creating a solid asset allocation strategy are vital to reaching your financial goals and managing investment risk. Your risk tolerance can change, so it’s crucial to reassess your goals and investment strategy regularly. Balancing risk and potential returns helps you confidently navigate the market.
While you balance all aspects of risk and rewards, consider consulting a SEBI-registered share market advisory for a comprehensive investment plan.
FAQs:
- What are the factors affecting risk tolerance?
Risk tolerance depends on several factors, including your financial situation, investment goals, time horizon, volatility, risk capacity, and more.
- What is meant by ‘risk-return trade-off’?
The risk/return trade-off means the more risk you take with an investment, the higher the return you expect, and vice versa.
