Risk and reward are closely aligned in investing. When it comes to balancing these two elements of investing, people have different risk tolerances and capacities. Therefore, before putting money in the market, investors need to determine their risk tolerance and capacity, and then develop portfolios that align with them.
Risk tolerance is a measure of the amount of risk an investor can comfortably endure. It is the degree of volatility an investor can withstand in the value of their portfolio.
Judging solely by risk tolerance, there are three types of investors: aggressive, conservative, and moderate investors. Aggressive investors have a very high tolerance for risk. They are willing to stomach extreme asset price fluctuations to achieve above-average returns. These investors are comfortable losing some of their principal if it means they have an opportunity to realize high returns on their investments. As such, these investors seek out high-risk-high-return investments such as growth equities, emerging market equities, and options.
Conservative investors are the opposite of aggressive investors. They have a very low tolerance for risk and would not be comfortable losing part of their principal. They prefer stable investments with guaranteed returns. These include bonds and cash accounts.
Moderate investors are found between the two above. They can take some risk in pursuit of relatively high returns but still prefer to have stable investments in their portfolio. Their approach to investing is more balanced.
An investor who wants to determine their risk tolerance can consult a financial planner. The financial professional will conduct an assessment to determine their risk tolerance. Afterward, they can work together to develop a portfolio that aligns with their risk tolerance and long-term goals.
Sometimes, financial planners recommend investors assume greater risk because they are capable of doing so. This is where risk capacity comes in. It is how much financial flexibility an investor has. While risk tolerance relates to the person, risk capacity relates to external factors like a person’s finances. While risk tolerance is somewhat innate and may not change throughout a person’s life, risk capacity is fluid and susceptible to change.
There are several factors that affect risk capacity. One is age. A 20-year-old has many years of earning and investing ahead of them, so they can take more risk with their money. Even if they have a low tolerance for risk, they can maintain their portfolios through periods of volatility because they have plenty of time ahead to make up for losses.
A 65-year-old in retirement, however, will have lower risk capacity, as they have less earning capability and live on income from their investments. If their investments were to fall in value, they will have a harder time making up for the loss.
Another factor affecting risk capacity is financial status. A high-net-worth individual will have a higher capacity for risk because their principal is large, meaning they can afford to spread money across diverse asset classes, including high risk ones. On the flip side, a person with a smaller portfolio and not much extra cash will not have the leeway to invest a lot in high risk assets. Their portfolios may not even survive the sharp price fluctuations of higher risk asset classes.
It is critical that investors work with financial planners to help them create portfolios that are aligned with both their risk tolerance and capacity. Such a proactive approach gives investors assurance that their portfolio is aligned with their needs. In this case, they are also much more likely to continue contributing to their investments to achieve their financial goals. Further, during market downturns, investors will be able to remain emotionally unaffected, avoiding impulsive decisions that could impede the realization of their long-term goals.
