Before you begin investing, it’s essential for you to be aware of your risk tolerance. The types of investments with which you fill your portfolio are dependent on your attitude towards risk. A good rule of thumb is to base your investment strategy on your risk tolerance.
In the investing world, the term ‘risk tolerance’ refers to the amount of risk an investor can bear. Risk can take on the form of market ups and downs, or stock volatility. To determine an investor’s risk tolerance, one can use a calculator or a questionnaire—much like personality tests—to categorize investing styles and make an informed decision based on the outcome.
There are three types of investor risk tolerance: aggressive, moderate, and conservative. To better understand which category you might fall under, we’ll expound a bit on all three below.
Aggressive risk tolerance
Most financial advisors agree that aggressive investors tend to be market-savvy. This knowledge allows them to purchase highly volatile instruments that can either garner high returns or none at all.
Aggressive investors can afford to do this not only because of their innate attitude toward the stock market but also because they can maintain a base that consists of riskless securities. So, their risk or hobby portfolio gives them the capacity to reach maximum returns with maximum risk.
Since their appetite for risk is enormous, in the event the stock market falls, most aggressive investors would choose to do nothing.
Moderate risk tolerance
Moderate investors strike a balance between their investments: they accept a level of risk, but they make sure that they have riskless securities in the mix. It isn’t uncommon to find a moderate investor pursuing a 50/50 structure, allowing them to play around with high-risk, high-return investments while at the same time keeping a good base of riskless securities.
In the event the stock market falls significantly, moderate investors play for the long-term by choosing to wait a few months before making a decision.
Conservative risk tolerance
Unlike the first two, prudent investors are not willing to accept highly volatile investment options. They prefer not to rock the boat by choosing investments that offer little to no risk. More often than not, retirees fall under this category since they can no longer afford to risk their hard-earned nest egg. However, some younger investors choose to take on a conservative approach.
Conservative investors are also called risk-averse, opting for secure investment products, like U.S. Treasuries or bank certificates of deposit (CDs). This strategy allows them to earn income while preserving their capital.
You can recognize the conservative investor in the event of a significant stock market downturn as they are usually among the first ones to immediately sell their stocks.
Make room for reality
Although understanding your tolerance for risk helps, you can’t accurately predict your behavior in times of crisis. It isn’t unusual to find that ‘aggressive’ investors are, in fact, ‘moderate’ or ‘conservative.’ Therefore, you have to make room for reality, and being realistic about your preferences can help you make the right investment choices now rather than going through the hassle of correcting them later.
If you’re figuring this out by yourself, one way to ensure the accuracy of your self-diagnosis is by reviewing some historical worst-case scenarios for various asset classes. Allowing yourself to confront real situations can give you an idea of how much you are comfortable losing. Also, keep in mind that other factors contribute to risk tolerance, such as the time horizon you have to invest, your earning capacity, and the presence of other assets, such as a pension, a home, or an inheritance.
Another thing that you might need to understand is your risk capacity, which refers to the amount of risk you can afford to take. Determining your risk capacity also depends on various factors, such as your time horizon to invest and the presence of extra capital. Another good rule of thumb when spending is that you can afford to take a higher risk when you have other stable sources of funds available, thus widening your risk capacity. Otherwise, it’s best to err on the side of caution by sticking to a more conservative, lower-risk portfolio.