In economics and finance, risk aversion is the behavior of humans, when exposed to uncertainty, in attempting to lower that uncertainty. It is the hesitation of a person to agree to a situation with an unknown payoff rather than another situation with a more predictable payoff but possibly lower expected payoff. For example, a risk-averse investor might choose to put their money into a bank account with a low but guaranteed interest rate, rather than into a stock that may have high expected returns, but also involves a chance of losing value.
Risk tolerance refers to the extent of volatility in the returns that an individual is willing to tolerate. This is an important investing term that eventually impacts performance of the investor’s portfolio. An investor should know the degree of market swings that he or she is willing and able to tolerate with the prospect of earning returns on investment.
Individuals with a high risk tolerance are known to have aggressive investment style. Most famous example of an investor with aggressive investment style is George Soros who during the early 1990s was able to earn about a billion dollars by aggressively investing in British pounds currency.
Individuals with a low risk tolerance are said to have conservative investment style. These investors tend to be risk averse and generally have a long term investment horizon. Warren Buffet’s investment style is considered to be risk-averse and conservative as he doesn’t take undue risks when making investments.
Investors that have a high risk tolerance take too much risk. This not only increases the prospect of earning high returns on investment but also raises the possibility of incurring large amount of losses. Contrarily, investors having a low risk tolerance do not earn the optimum return on investments.
How to Assess Degree of Risk Tolerance
Investors can determine the extent of their risk tolerance by answering a number of questions related to risk tolerance. These questionnaires are offered online that are used to accurately gauge the degree of risk tolerance of an individual.
Additionally, it helps to review worst case situation of different asset classes in the portfolio. This can be assessed by evaluating historical prices of the assets. The action can help in getting an idea about the extent of loss that is bearable for the investor.
Apart from extent of losses, other factors that affect the risk tolerance of the individual include future earning capacity, investment time horizon, and presence of other securities in the portfolio such as inheritance, social security, and pension. A person would be willing to take on increased risk when other stable sources of finance are available.
To sum up, a risk tolerant investor will invest in risky assets that have a higher potential of returns. While a person who is risk averse will invest in stable financial instrument with the intent of minimizing the risk of loss on investment.
Risk Tolerance FAQ
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- Financial risk tolerance and additional factors that affect risk taking in everyday money matters – link.springer.com [PDF]
- Does risk tolerance decrease with age? – papers.ssrn.com [PDF]
- Changes in financial risk tolerance, 1983-2001 – papers.ssrn.com [PDF]
- Nonlinear linkages between financial risk tolerance and demographic characteristics – www.tandfonline.com [PDF]
- The financial risk tolerance of Blacks, Hispanics and Whites – papers.ssrn.com [PDF]
- Understanding and assessing financial risk tolerance: a biological perspective – www.tandfonline.com [PDF]