Risk Tolerance What is Risk Tolerance?

Risk tolerance is a measure of your willingness to accept higher risk or volatility in exchange for higher potential returns according to the standard definition of risk tolerance. But the standard definition doesn’t tell the full story.

There are two questions associated with risk tolerance that must be answered. The first question as you might imagine is, How much risk should you take on? The second question that goes hand in hand with question number one is, How much risk can you handle psychologically?

Two very good questions someone should themselves ask before they jump headlong into the investing swirling waters. Risk and volatility will always be present in a free market therefore having an answer to these risk tolerance questions seems to be mandatory.

They obviously won’t have identical answers. After all, they are two separate questions. However they could have the same answer. If you believe you cannot handle risk at all, the answer will always be none.

Most of us don’t operate in a zero risk tolerance world. We actually put some of our money at risk in the stock market, real estate market, commodities market, futures market, etc.

Of course just because you want to take a risk doesn’t mean you should. Most of us put that thought out of our mind and make the investment. We can accept that maybe we shouldn’t but the investment is simply irresistible for our own select reasons.

As you might guess, people with a high risk tolerance level are called aggressive investors. They are willing to accept losing money in search for high returns or even hitting it out of the park.

People with a low risk tolerance are called conservative investors.

This set of investors is more concerned with capital preservation. Another term associated with the conservative investor is risk-averse. No matter what they are called they are not aggressive by any stretch of the imagination.

All of this brings into question an investor’s financial ability or capacity as it is sometimes called to tolerate risk. Who can tolerate risk better?

The answer to that question depends on the financial capacity of the individual one could argue and probably argue correctly. Take a gentleman like Warren buffet. He is reputed to be worth about $50 billion.

With that kind of net worth most of us would say we could live quite comfortably. But, let’s assume his net worth is reduced by one half because of a very bad investment decision. He is now worth only $25 billion.

Most of us would say we could live quite comfortably with that net worth. Mr. Buffet would say the same thing although he may not enjoy his circumstance. It certainly wouldn’t be incorrect to say his capacity to absorb this loss is adequate indeed. And given this huge net worth it would be fair to assume he could leverage back to $50 billion.

On the other hand a worker in his mid-30’s or early 40’s with a portfolio of $200,000 takes the same percentage, 50%, hit. His portfolio is now $100,000. His financial capacity is severely impacted.

Chances are excellent he is still supporting a family and has a mountain of financial obligations staring him in the face. This type of hit has the potential to cripple both his lifestyle and retirement plans.

An 18 year old recently hired young person has a portfolio worth $1000. He takes a 50% slap as well. His capacity to absorb this same percentage is as high as Mr. Buffet. This person has many years ahead of him to take advantage of financial management principles as well as increasing his income.

As you read these scenarios you can easily determine that risk tolerance is more complex than just your willingness to accept higher risk or volatility in exchange for higher potential returns. You have to understand several more factors on the risk tolerance spectrum. Once you understand them, you can develop a portfolio with the risk tolerance level that is most appropriate to your circumstances.