Investing is an essential part of personal finance. However, it does come with a fair share of risks. Everyone has a unique approach to handling such risks. This is where risk tolerance comes into the picture.

What is risk tolerance?

Risk tolerance is the degree of investment return variability an investor is willing to accept. It is a fundamental consideration before investors make any financial strategy or investment decision. The ability and willingness to handle risk, particularly in investment choices, depend on individual personality characteristics and financial circumstances.

There are three types of risk tolerance:

• High Risk Tolerance (Aggressive): Investors are willing to accept the possibility of losing money in exchange for the potential of higher returns.
• Moderate Risk Tolerance (Balanced): Investors are ready for some losses, but they prefer a mix of small and large gains.
• Low Risk Tolerance (Conservative): Investors prefer lower returns to avoid potential losses.

What is assessed in risk tolerance?

Several important factors are taken into consideration when assessing an individual’s risk tolerance:

• Financial capacity – The ability to withstand financial losses. An individual with a high net worth and stable income may have a higher risk tolerance than someone with lower financial capacity.
• Investment goals – Longer time horizons may allow some individuals to be more comfortable with risk, though market performance cannot be predicted or guaranteed.
• Investing time horizon – Longer time horizons may withstand a higher risk tolerance, as the investor has more time to recover from potential losses.
• Investment knowledge – People with extensive investment knowledge and experience often have a higher risk tolerance because they understand the market’s volatility.
• Risk attitude – The psychological component of risk tolerance. It refers to how comfortable an individual is with taking risks.

How financial professionals assess risk tolerance

Financial professionals use various methods to assess an investor’s risk tolerance. Here are some common approaches:

• Questionnaires and surveys – Financial professionals use risk-profile questionnaires to understand an investor’s risk capacity and risk attitude. These questionnaires typically include hypothetical scenarios to gauge how an investor would react in different market situations.
• Psychometric testing – These tests help financial professionals assess an investor’s psychological risk tolerance. They delve into the client’s behavioral patterns and risk-taking tendencies.
• Discussions and consultations – Financial professionals often have detailed conversations with clients to understand their financial goals, financial situation, and personal comfort with risk.
• Financial analysis – Financial professionals perform a detailed analysis of the client’s financial situation, including income, expenses, assets, and liabilities. This analysis helps them understand the client’s financial capacity to bear risks.

Understanding risk tolerance when investing is crucial for making appropriate investment decisions. It helps investors understand how much risk they are comfortable with and which investments are suitable for their goals and personal circumstances.

Each investor should recognize their risk tolerance and adopt an investment strategy that suits them. Remember, the goal of investing is not just to make significant gains, but also to feel comfortable investing.

SWG5045536-1225c This information is provided as general information and is not intended to be specific financial guidance. Investing involves risk, including the possible loss of principal. Past performance does not guarantee future results. Before making decisions about your personal financial situation, consult a qualified financial or tax professional who can review your individual circumstances and objectives. The sources used to prepare this material are believed to be accurate and reliable but are not guaranteed.