Anyone who plans to become a broker needs to realize that there is no way of escaping the stress and emotional turmoil. Every trader should be able to measure and determine the risk tolerance in trading as it is one of the most critical steps. Thus, risk tolerance is an essential component in investing.
Remember, once you know how much market risk and pressure you can tolerate, you can choose suitable investments that match your risk profile. It would help if you always had a realistic understanding of your abilities and an adequate willingness to stomach the fact that you will face some loss while investing or trading.
However, the investing terminology risk tolerance relates to the amount of market risk and volatility an investor can tolerate. Risk tolerance is often associated with age and experience, although that is not the only determining factor. But age itself should not determine a switch in asset classes. Those with a higher net worth and more disposable income can also typically afford to take higher risks with their investments.
Risk tolerance is more frequently used by a financial specialist when categorizing investors and their investing styles.
Types of Risk Tolerance
Aggressive Risk Tolerance
Aggressive investors are usually very market-savvy and have a deep understanding of securities and institutional investments. This type of investor tends to put a large part of their portfolios into stocks, ETFs, or other companies. They buy volatile instruments, such as small-company stocks that can plummet to zero or options contracts that can expire worthlessly. With maximum risk, they tend to reach for maximum return. Aggressive investors manage to maintain riskless securities.
It’s essential to keep in mind that higher risk doesn’t automatically equate to higher returns.
Conservative Risk Tolerance
Conservative investors value protecting the principal over seeking appreciation. These types of investors are comfortable with accepting a small degree of risk and volatility to find some degree of profit. These investors desire greater liquidity and are willing to accept lower returns.
Moderate Risk Tolerance
Moderate investors mostly value risk-reducing strategies and enhancing returns tactics equally. This type of investors’ typical strategy might involve investing half of the portfolio in a dividend-paying growth fund. These investors will usually combine large-company mutual funds with riskless securities and less volatile bonds.
A Guide to Risk and Diversification
The easiest way to minimize risk is diversification, which is based heavily on the concepts of correlation and risk. However, while most investment professionals agree that diversification can’t guarantee against a loss, a well-diversified portfolio can help an investor reach long-range financial goals.
Here are some tips on how to ensure adequate diversification:
- Spread your portfolio among many different investment vehicles: stocks, mutual funds, bonds, cash, ETFs, etc. In this case, if something goes wrong, and if part of your portfolio is declining, the rest may still be growing.
- Stay diversified within each type of investment. Try to include various securities that differ by industry, region, market capitalization, and sector.
- Include securities that vary in risk as you are not restricted to picking only specific types of stocks: like blue-chip.
However, please remember that portfolio diversification is not a one-time task. Finding the right balance between risk and return helps investors and business managers achieve their financial goals through investments. Make your life easier and be smarter!
Takeaways to Remember
- A person’s age, income, investment goals, and comfort level play an essential role in determining traders’ risk tolerance.
- An aggressive investor, or someone with higher risk tolerance, is willing to risk more money than a conservative investor, who has a lower understanding.
- A moderate investor holds the middle ground and finds the balance between an aggressive and conservative investor.
- Risk tolerance is a measure of the amount of loss an investor is willing to endure within his or her portfolio.