What is risk tolerance?

In general

How do you feel about taking risks? Take this short quiz:

1. Do you put on the car brake when the traffic light turns yellow, or do you step on the gas? If you put on the brake, give yourself one point. If you step on the gas, give yourself three points.

2. Do you fill the gas tank when the needle reaches halfway, or do you run a few miles on empty? If you fill the tank halfway, give yourself one point. If you run on empty, give yourself three points.

3. Do you take the long way because it’s the way you know, or will you take a shortcut you’ve never taken before? If you take the long way, give yourself one point. If you’ll take the shortcut, give yourself three points.

4. Do you take the train long distances, or do you prefer to fly? If you take the train, give yourself one point. If you fly, give yourself three points.

Now, add up your points. The maximum score is 12 points, and the minimum is 4. Most people will fall somewhere in between. Your score reflects your attitude toward risk and indicates your ability to accept or tolerate risk. Those of you with a higher score can accept a relatively great amount of risk and are referred to as risk tolerant. On the other end of the spectrum, those of you who scored low can accept very little risk and are referred to as risk averse. Many people fall in between the two ends of the spectrum.

Note: This quiz is not scientifically based–it’s being used only to illustrate a point. Quantifying risk tolerance is not an exact science. See below for more on this.

Risk tolerance in the investment world

In the investment world, there are two aspects of risk tolerance: (1) an investor’s capacity for risk, or ability to absorb losses, and (2) how comfortable an investor is with risk.

An investor’s capacity for risk is looked at purely from a financial point of view. In other words, the simple question is asked: How much money can the investor afford to lose? An investor who depends on his or her investments to pay daily expenses and for whom a loss would represent a serious problem has less risk tolerance than someone for whom an investment loss might merely be an inconvenience or disappointment.

How comfortable an investor is with risk, from an emotional standpoint, depends on many factors, including his or her objectives and goals, life stage, personality, knowledge of investing, and investment experience. Some investors will hang on to an investment during downturns in the market, while others will bail out at the first sign of trouble. You should only invest as much as you are comfortable with. If you find yourself losing sleep worrying about your investments, you may have invested too much or too aggressively.

Investors typically fall into three categories of risk tolerance: aggressive (those who are risk tolerant), conservative (those who are risk averse), or moderate (those who are somewhere in between).

How risk tolerant you are is important, because it is one of the basic factors in determining the best investment strategy for you. Your risk tolerance can affect both the types of investments you make and the way you choose to diversify your portfolio.

What is investment risk?

In the investment world, risk means uncertainty, and refers to the possibility that you will lose your investment or that an investment will yield less than its anticipated return. That uncertainty about the outcome of an investment means that investment risk also refers to the way the price of an investment fluctuates or changes in value from time to time–its price volatility. The more the fluctuation–in frequency and in amount–the higher the volatility. Generally, the higher the volatility, the greater the uncertainty about the outcome of your investment, and the greater the potential risk involved.

There are three factors that are key to understanding risk : (1) the risk-return tradeoff, (2) the investment planning time horizon, and (3) the different types of risks that exist. You should have a solid understanding of each of these issues in order to select investments that maximize potential returns within your acceptable risk levels. Here is a brief discussion of each.

As risk increases, the potential for return increases. This is known as the risk-return tradeoff. Historically, investments with greater risk have tended to provide higher returns, though past results are no guarantee of future returns. The more aggressive you are as an investor, the more risk you take, and the greater chance you may have to earn a potentially higher return (assuming any return is earned at all). Conversely, the more conservative you are as an investor, the less risk you take, and the less potential you have to earn a high return (though you’re also less likely to lose your investment).

The length of time you plan to stay invested in a particular vehicle is referred to as your investment planning time horizon. Generally speaking, the longer your time horizon, the more you may be able to afford to invest more aggressively, in higher-risk investments. This is because the longer you can remain invested, the more time you’ll have to ride out fluctuations in the hope of getting a greater reward in the future.

Finally, many types of risk can affect an investment. Each investment is subject to all of the general risks associated with that type of investment. Risk also arises from factors and circumstances specific to a particular company, industry, or class of investments.

Note: All investing involves risk, including the potential loss of principal, and there is no assurance that any investment strategy will be successful.

The role of change

An investor’s risk tolerance may not be static (although authorities argue about this). Personal and outside factors may influence your risk tolerance at any given time or over a period of time. Thus, you might expect changes in your feelings about risk when there are increases or decreases in your family obligations, major shifts in the economy, or other such circumstances. It is wise to be prepared to modify your investment plan should such changes occur.

How is risk tolerance measured?

Not an exact science

There are tests that measure risk tolerance to assess how an investor reacts to different types of risk. These tests aren’t foolproof, of course, since we are talking about psychological behaviors that can vary under different conditions. However, these tests are designed to give you a general sense of how much investment risk you can accept, and the results are generally considered reliable. Generally, risk tolerance tests fall into two categories: investment preference tests and psychological tests.

Investment preference tests

Typically, an investment preference test is a questionnaire that addresses preferences for selected investment vehicles. It asks questions about your current financial situation, goals, and past investment experience. This type of test is easy to construct and relatively simple. The disadvantage, though, is that it does not accurately gauge risk-taking propensity because it does not deal with emotional reactions to risk.

Psychological tests

A psychological test is a more elaborate questionnaire that attempts to gauge an investor’s attitude toward risk. This type of test generally includes questions about your feelings or behavior, or it may ask you to respond to hypothetical situations. This method of testing is easy to administer and can actually be fun to take. The disadvantage is that people often like to consider themselves risk-takers and may not respond as accurately as they should, only to find out during their first market downturn that they are more risk-averse than they had thought.