Some investors are willing to take risks, but might not have the ability to do so. While other investors may have a high ability to take risks, but due to their risk aversion preference, are not willing to take high risks. An investor’s overall risk tolerance is determined by looking at both, the ability and willingness. There are several factors one needs to consider when determining their risk profile. But first, let’s start by understanding the difference between these different types of risks.
In a nutshell, your ability to take on risks depends on your surplus. Of course, before you can take on risks, you must know what is a risk and have something to place at risk. Therefore, your ability can be quantified primarily through your net worth or your wealth relative to your debt. Other factors that are considered in determining your ability to take on risks are your time horizon, human capital, and expected income from investing (Read this article on risk tolerance for more information: Your Risk Tolerance: Are You Willing to Risk It All?).
For example, if you are in your late 20’s with a stable job, you are unlikely to tap into your savings for retirement in the next ten, twenty, thirty years – give or take. Since your time horizon is relatively long, you are able to invest more in stocks; which are relatively riskier and advisable for long-term investors. However, if you are already 50-ish (Come on, age is just a number, right?) and closer to retirement, it is generally advisable to allot fixed-income investments such as bonds in your portfolio.
On the other hand, willingness refers to the degree of investment risk one is comfortable taking. An investor may say in the beginning “I can handle the inevitable market fluctuations” but this resiliency will eventually be put to the test. In the end, it all comes down to how you will react when your investment portfolio loses its value. In short, can you still sleep soundly at night after you’ve made an investment decision? If the answer is no, then you might have exceeded your willingness threshold.
Short-term market volatility, especially in equity investments (i.e., stocks), is inevitable. One of the most common investing pitfalls is panicking when the bear shows up! Investors should avoid panic selling and consider rebalancing their portfolio to mitigate the risks. To find out more on mitigating risk, read The First Thing You Need to Know About Diversification.
Your willingness to take risk depends on a number of factors such as your personality type, self-esteem, investing experience, financial security, inclination to independent thinking and resiliency.
In conclusion, your overall risk tolerance is the lower between your willingness and ability to take risks. Here are a couple of examples:
Note: Some of the elements used in the illustration were obtained from Freepik.com.
If you’re young:
- If you’re young and at the prime of your life, your time horizon to achieve your financial goals is much longer. Therefore, your ability to take risk is high. However, let’s say you, as a person, are pretty conservative in approaching investments – you are extremely risk-averse. With this, your willingness to take risk is low. Therefore, your risk tolerance is low.
If you’re older:
- Say you’re already close to retirement – your time horizon is relatively shorter. Your ability to take risk becomes lower as you grow older. However, your personality is aggressive and you tend to be a risk-taker when it comes to investing. Your willingness to take risks is high. In this case, your overall risk tolerance is low. You might be willing, but you’re not able to take much risk anymore.