The terms risk tolerance or risk-bearing capacity are often used when it comes to portfolio advice. Both terms can be used as synonyms since both refer to the personal ability of an individual investor to tolerate and handle investment risk in their portfolio. This means the risk tolerance of an investor refers to the degree of variability in investment returns that an individual is willing to withstand in their investment portfolio. It reflects the investor’s capacity and willingness to endure losses or fluctuations in the value of their investments.
To determine the personal risk tolerance or risk-bearing capacity of an individual investor, financial advisors and trading platforms evaluate several factors ranging from the financial situation (income, expenses, net worth, liquidity needs, investment horizon, etc.) of the investor via psychological factors/emotional comfort (tolerance for volatility, reactions to market downturns, etc.) to behavioral factors (investment history, decision making process, etc.) including an evaluation of how well the investors understand different types of risk (market risk, credit risk, interest rate risk, inflation, etc.).
The evaluation of the risk tolerance of an investor is only the first step in building a suitable portfolio. It is at least as important to evaluate the goals and investment objectives of the investor, since it is crucial to align the portfolio strategy/strategic asset allocation with risk tolerance and investment goals.
With regard to this, an investor’s financial goals are normally split into three categories with regard to their investment horizon:
– Short-term goals: Goals to be achieved within one to three years.
– Medium-term goals: Goals to be achieved within three to seven years.
– Long-term goals: Goals to be achieved in seven-plus years.
Generally speaking, longer investment horizons often allow investments with higher risk levels, while not all asset types and classes are suitable for short- and medium-term investment horizons, regardless of the risk-bearing capacity of the investor. That said, risk tolerance also helps determine the asset selection for long-term goals. The investor needs to understand the implications of his risk-bearing capacity on the return expectations for his portfolio and the respective impact on the defined investment goals.
At the end of the evaluation, the investor is classified in a risk tolerance category which determines the eligible assets and their allowed contribution to the overall risk budget for the portfolio construction process. The number of risk tolerance categories depends on the advisor but will in most cases somewhere between three and seven. Below you will find a brief description of the three core categories.
Aggressive/high risk tolerance:
– The investor is willing to accept high levels of risk for the potential of higher returns.
– The investor is comfortable with significant fluctuations of the portfolio value (high volatility).
This category is in general suitable for investors with long investment horizons, strong financial positions, and a high risk-bearing capacity.
Moderate/balanced/medium risk tolerance:
– The investor accepts a balanced level of risk and return.
– The investor prefers a mix of growth-oriented investments and stable income-producing assets, like the classic 60/40 portfolio.
This category is in general suitable for investors with a medium- to long-term investment horizon, a moderate financial stability, and a medium risk-bearing capacity.
Conservative/low risk tolerance:
– The investor prefers low levels of risk, prioritizing capital preservation over high returns.
– The investor favors stable, low-volatility investments such as bonds and cash equivalents.
This category is suitable for investors with a short-term investment horizon, lower financial capacity to absorb losses, and/or a low risk-bearing capacity.
Once the risk-bearing capacity has been evaluated it helps to compose a strategic asset allocation that aligns the expected risk and return profile of the portfolio with the investor’s comfort level and financial goals. It also helps to select appropriate asset classes and investment vehicles to build the respective portfolio. In addition, the evaluation of the risk tolerance ensures that the investment plan and strategy are sustainable and aligned with the investor’s long-term objectives.
Since the personal situation of an investor will change over time, investors (and advisors) should do regular reviews of the risk-bearing capacity of an investor on an annual or semi-annual basis. That said, the risk tolerance of an investors needs to be re-evaluated after any kind of significant life event such as marriage, birth of a child, job change, etc. These reviews shall ensure that the portfolio guidelines with regard to the risk tolerance are reflecting changing circumstances in the life of the investor and ensure the alignment of the portfolio guidelines with the investor’s financial objectives.
In a nutshell, it can be said that understanding and accurately assessing the risk tolerance of an investor is crucial for developing an investment strategy that meets the investor’s needs while ensuring they remain comfortable and confident with their investment decisions.
This article is for information purposes only and does not constitute any investment advice.
The views expressed are the views of the author, not necessarily those of LSEG Lipper or LSEG.
