What is Your Risk Tolerance?
An Acceler8now.com Investing Education Resource July, 2007
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Because investment has to deal with the future, which can never be predicted with absolute accuracy, it immediately acquires a risk dimension. When you stake your money on the future, no matter your level of analysis or insight, a degree of likelihood that the eventual outcome will vary from expectation is present. Each investment option will, however, have its own risk profile. Some are marginally risky, while some get really highly risky. Interestingly, investment risk has been found to have its reward in investment returns. The expected return rises in direct proportion to the level of risk: more risk, more expectation of higher returns. You can choose, for instance, to play safe and invest in Federal Government bonds. Because of the sovereign backing of the State, you have a highly secure investment. You must, however, limit yourself to the fixed interest rate of the bond. While your friend buys a stock that could turn out no earnings and even suffer a price decline, don't envy him if the stock turns out a goldmine, appreciating by 120% in four months. That's the dimension risk brings into it.
But how much risk can you take as an individual? The reality is that each investor has a personal risk tolerance, beyond which he is jittery and wouldn't commit his resources. This is natural. Different persons have varying risk-absorption capacities. Some are risk averse while some are less sensitive to danger. This reflects in their investment attitudes. Risk tolerance is also defined by factors such as age. Generally, a younger investor, who has enough time to recover from investment errors, will tend to be more aggressive. In contrast, an aged investor who, if he loses a substantial part of what he has saved, will hardly have enough time for recovery, will tend to be more cautious. Experts have attempted, over time, to categorise investors on the basis of their risk psychology. One classification identifies the following categories:
- Aggressive investors - hardly risk averse, ready to stake for a big outcome
- Moderate investors - average people, ready for reasonable risks but not prepared to go overboard.
- Conservative investors - risk-shy, closely guarding existing resources and ready to forgo a chance of possible gain if the associated risk is significant.
- Other positions in between these major levels, where many other investors fit in in the continuum.
 Another investor behavioural model by Bairlard, Biehl and Kaiser classifies investors on the basis of:
(1) confidence - confident or anxious and (2) action orientation - careful or impetuous. Five investor types emerge:
- individualistic
- adventurer
- guardian
- celebrity and
- straight arrow.
Individualists are careful and confident, often preferring to do it their way. Adventurers are more enterprising and venturesome, strong-willed and more disposed to risk. Celebrity investors follow the crowd and noise. Guardians are cautious, risk-averse and very protective of their investment. The 5th group is somewhere in between, sharing the attributes.
All said, the clear message is that the individual investor must understand where he fits in. The reason is that this understanding will help define what investment options and opportunities are for him. If he is risk-averse and chooses to dabble into a highly risky investment, he could harm his health, for instance.
Now, for you personally, before you proceed with taking investment positions, where to you belong? Have you assessed yourself? What do you see? If not sure and you would like some help assessing your risk temperament, take this quiz to find out how you score:
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