Risk Tolerance is an important consideration when determining what an investor’s portfolio should consist of. In the most basic terms an investor’s Risk Tolerance is their willingness to withstand investment losses. Time-frame is a component of risk tolerance as well. Some investors fear losses over any time frame, short or long, while others are comfortable with short term losses so long as they generally experience growth over a multi-year period. This time-based tolerance for losses is an emotional measure of how much risk an investor can handle. Determining an investor’s risk tolerance seeks to gauge the investor’s appetite for risk versus expected return and focuses on their ability to be comfortable with potential losses over short and longer-term time frames.
Risk tolerance is generally categorized using a three or five tier scale. For simplicity we will illustrate a typical three tier risk tolerance framework.
Conservative: A Conservative investor’s primary objective is to protect their principal. Typically, this investor accepts lower returns (such as 1-5% per year) for more stability. Minimizing risk and loss of principal, over both short and long term time horizons, is important to a Conservative investor.
Moderate: A Moderate investor accepts modest risks to seek somewhat higher (such as 3-7% per year) long-term returns. This investor may experience modest short-term loss of principal in exchange for more long-term appreciation. A Moderate strikes a balance between investing in a conservative and aggressive manner accepting some short-term loss risk for the chance to achieve more long-term return.
Aggressive: An Aggressive investor is willing to take on more risk to maximize long-term returns (such as 8-10%+ per year). Protecting principal in the short-term is not a concern of an Aggressive investor. This type of investor understands that they may encounter considerable volatility and significant losses in the short term and, over a multi-year period, is likely to have the highest cumulative returns.
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