What is your Risk Tolerance?

If the possibility of an investment doubling in 2 years is 60%, then what percentage of your money would you invest. Think carefully before you answer. You might say you are willing to bet 30% of your savings, but somebody else might say 50% or any other percentage. Why is the answer different even though everyone is faced with the same probability and possibility. The reason is that everybody's personal situation is different. That is why everyone has to assess their own personal situation before taking on risks while hoping for higher returns.

Risk tolerance is your personal tolerance for accepting investment risk in return for higher potential returns. And the Investment Risk is the uncertainty of earning investment returns. In the investment world, Risk is measured in terms of volatility or standard deviation of returns.

So what is your risk tolerance? The answer depends on your age, your net worth, your trading experience, your risk capital, the risk-reward ratio of the investment. Some of the general factors that determine how much risk tolerance you can weather are

1. Time Horizon: When is the investment money (& returns) needed. If the investment money is needed immediately, then there is no room for making any error in the investment process. Hence risk tolerance is low and, conservative investment is a good choice. Eg: Certificate of Deposit or Treasury Notes or Money market accounts.

If however you are investing for your retirement and you have relatively longer time to digest variations in investment returns, then you can be aggressive in your investment. You can invest in high income bonds or mutual funds or stocks or in real estate.

If your financial appetite can stomach a super aggressive portfolio, then you go for options, futures and collectibles.

2. Risk Capital: $1,000 means different value for a person earning $25,000 a year than a person making $75,000 a year. Thats the point. Risk Capital is the money that is available to invest, and is not going to affect the lifestyle if lost. That is, the smaller the percentage of investment compared to your overall net worth (= total assets - total liabilities), the higher can your risk tolerance be.

If an under-capitalized trader assumes too much risk, then he might be forced out of the game early. This is because his one investment will be a bigger percentage of his overall investment capital. On the other hand, a high net worth trader might not be affected by a single risky trade since this trade only constitutes a small percent of his overall portfolio. As a result, the high network guy can continue to trade the next day and maybe, trade many more times.

3. Trading Experience: If you are new to investing and trading, then you are less inclined to bet higher amounts in a single trade. But if you are an experienced confident trader, you are willing to bet higher on what is seeming a sure shot.

Depending on the level of your experience, your comfort level in amount of investment varies.

4. Investment Objective: Do you really want to take on too much risk in your retirement portfolio? Because you don't get too many chances to rebuild your retirement nest egg and you may need to be careful in risking your retirement capital. However you might be fine risking the money that you are using make some extra bucks.

Certain investments are too valuable to subject them to higher volatility.

5. Personality: All other factors being the same, different people choose different margin of safety. It is just the innate nature of certain people to feel more comfortable with safety and hence less risk tolerance.

An investor dare-devil might display more risk acceptance than a cautious investor. That is because the dare devil can feel comfortable by pushing himself to the limits. But a risk averse investor, with all the factors remaining the same, might choose a less aggressive portfolio. Just an individual comfort level in choosing a point on fear-greed continuum.

Regardless of which of the above factor plays to your pulse, you need to understand your risk tolerance and be aware of how much risk you can take on. Understanding what is Risk Tolerance is the first step. Risk tolerance is a process of assessing your personal financial situation and trading that off with your financial goals. Taking time to analyze your personal situation is the next step. When you understand your risk tolerance and when you invest accordingly, you will not only be able to sleep better but you would also have taken a step towards reaching your financial goals.

No matter what level of investor you are, keep in mind what Warren Buffet said about rules of investing:

Rule #1: Do not loose money
Rule #2: Follow rule #1

-Nidhi

This post is greatly influenced by this article from Chad Butler: