Risk Tolerance 101: Know Your Appetite

Do you consider yourself a risk-taker or someone who prefers to play it safe?

All investments carry some degree of risk. Some individuals thrive on adrenaline-pumping ventures, seeking out opportunities where others may hesitate. On the other end, some prefer a more cautious approach, desiring stability and predictability. Wherever you find yourself on the spectrum of risk tolerance, it is crucial to know how you respond to it and how you can leverage it to your advantage when making informed decisions.

What is risk tolerance?

By definition, risk tolerance is an investor’s ability to handle variability in portfolio returns, and it presents in practice as the ability and willingness to take investment risks. It is how much you are willing to be unsure about (and how much money one is willing to lose) in the face of possible gains.

For instance, if the thought of losing a significant portion of any capital is unacceptable to you, your risk tolerance probably is very low. However, if you are comfortable with risking a part of your funds in pursuit of substantial gains, your risk tolerance would be higher.

What shapes my risk tolerance?

Risk appetite looks different from one trader to another. Be it personal or financial factors, risk tolerance is significantly dependent on them. Let’s look at some influencing factors below.

Age

Generally speaking, there is an inverse relationship between age and risk tolerance. Young investors typically have more working years ahead of them to earn and invest their money, so they exhibit higher risk tolerance than older investors. Pre-retirees and retirees who depend solely on investments for their living expenses may be more susceptible to market fluctuations. Of course, this isn’t always the case.

Experience

Experienced traders in the trading game often develop valuable instincts and a sense of confidence over time. As a natural progression, increasing position size may be a beneficial step for them. However, novice traders, who are still navigating the learning curve, may find themselves vulnerable to strong emotions that can heavily impact their trading decisions. In such cases, novice traders tend to have a lower risk tolerance, opting for smaller position sizes to maintain a more controlled trading experience.

Trading capital

Depending on the size of the trader’s trading capital, the level of risk tolerance also differs. A larger trading account empowers traders to assume larger positions per trade, meaning they can stomach higher risks. On the other hand, traders with smaller accounts would typically exercise caution, as trading standard or mini lots can put them at risk of experiencing a margin call, particularly in the face of even minor market volatility.

Which risk tolerance group am I in?

Risk tolerance can be broadly categorized into three main groups:

Conservative

To put it simply, conservative investors have a lower-than-average appetite for risk. They prefer investment portfolios with little to no volatility, such as safe options that offer more guarantees and high liquidity. These include money market funds, bank certificates of deposit (CDs), some fixed-income securities, and real assets.

Moderate

Investors in the moderate category have a middle-of-the-road view of investment risk. They aim to grow their wealth without incurring significant losses. They often adopt a balanced strategy, with an asset allocation of around 50% in common stocks, 40% in fixed-income securities, and 10% in cash.

Aggressive

An aggressive investor is willing and able to risk losing money for better gains. Usually, they tend to have a deeper understanding of the volatility of securities and set up their strategies around capital appreciation instead of income or preserving their principal investment. Commonly, their portfolio includes stocks and other volatile assets, such as cryptocurrency or NFTs, with little to no allocation to bonds or cash.

Final thoughts

Those who constantly feel anxious about their account balance and find it difficult to concentrate on their trading performance may find reducing the risk percentage beneficial. On the other hand, if the potential gains do not appear promising enough, increasing the average position size could be the next strategy.

When it comes to risk tolerance, traders need to be honest with themselves and thoroughly consider the various factors that impact their entire investment portfolio. There is no one-size-fits-all formula for risk-taking, and the level of risk one is willing to undertake ultimately depends on their personal preferences and circumstances.