Determinants of Investment Risk Tolerance

 

Investment risk tolerance is an individual’s ability and willingness to endure losses or fluctuations in the value of their investments. In other words, how comfortable someone is with the possibility of losing money or experiencing volatility in pursuit of potential gains.

Risk tolerance varies from person to person and is shaped by a variety of factors. Knowing your personal investment risk tolerance plays a key role in determining suitable investments. Below are six key factors that affect individuals’ mindsets about investment risks:

Age and Life Stage- Younger investors often accept more risk than older adults because they have a longer time to recover from market downturns and portfolio losses. In addition, life changes such as marriage, parenthood, or retirement may reduce willingness to take risks.

Time Horizon- Long-term goals (e.g., retirement in 30 years) support purchasing investments like stock that require a higher risk tolerance. Short-term goals (e.g., buying a car next year) require safer, less volatile investments.

Income Stability- Investors with a chance of unemployment or an irregular income may choose to invest more conservatively. Conversely, secure employment (or a pension) and a consistent, high income provides a safety net that can encourage greater investment risk.

Net Worth- An investor can afford to take more risk with a six-figure net worth (assets minus debts) than a net worth of less than $10,000 because a high net worth allows investors to absorb losses more easily. Conversely, individuals with fewer assets and/or more debt may avoid risky investments. A well-funded emergency fund can increase comfort with risk.

Investment Knowledge and Experience- Informed investors understand market trends and risks. In addition, experience with market volatility can improve comfort with risk. Novice investors, on the other hand, may be more cautious due to lack of experience and limit themselves to low-risk savings products such as money market funds and CDs.

Economic Environment- Strong financial markets often boost investor optimism and risk-taking behavior. Recessions, inflation, or geopolitical tension can cause fear and conservatism. Media coverage of economic news can also sway investor confidence.

Take the time to assess your own personal investment risk tolerance. A good tool to use is the University of Missouri’s online Investment Risk Tolerance Assessment. Remember, there is no one “right” risk tolerance. Rather, risk tolerance is personal and reflects an individual’s values, emotions, and experiences.

        

This post provides general personal finance or consumer decision-making information and does not address all the variables that apply to an individual’s unique situation. It does not endorse specific products or services and should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.