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What is 'Risk Tolerance' and How Does a Financial Advisor Use it When Investing?

by Sandy Pepper
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Risk tolerance is the amount of loss an investor is willing to handle when making an investment decision. Before you choose the best investment for your goals, you start by measuring and determining the level of risk you are willing to withstand in your financial planning.



But risk tolerance is crucial not only to you as an investor but also to financial advisors who help clients reach their financial goals. They have to assess the degree of market risk an investor can tolerate before investing money on their behalf. But perhaps you wonder how these planners determine your risk level before choosing the ideal investments that match your risk profile.

 

This post explains how financial advisors evaluate your risk tolerance for them to invest your money.  

Understanding Risk Tolerance

Investors have a lot of questions regarding risk tolerance. These include:

  • What is my risk tolerance?
  • How is risk tolerance calculated?

What Is My Risk Tolerance?

Several factors influence the amount of risk you can tolerate, including:

1.    Timeline

Investors adopt varying time horizons depending on their investment plans. For example, if you need a certain amount of money in the future, let say 15 years, you may take more risk than when you need the same figure in five years.

2.    Goals

Financial goals differ among investors. As such, different people will have different risk tolerance according to their respective goals. For example, if you aim to own a five-bedroom mansion by 35, you will have to take more risk in your investment portfolio than when your goal is to own a two-bedroom house by the same age.

3.    Age

Young investors can take more risk than older investors since they have a longer time horizon to handle market changes.

4.    Portfolio Size

Investors with a large portfolio may be more risk-tolerant. Therefore, if you have more disposable income and a higher net worth, you may be able to take greater risks with your portfolio.

5.    Your Comfort Level

You could be more or less naturally comfortable taking risks than other people, and this has a direct relation to your risk tolerance.

How is Risk Tolerance Calculated?

Financial advisors calculate risk tolerance by asking many questions and weighing the answers to categorize their clients according to the level of risk they can tolerate.

Some of the questions include:

  • Where do you see your life several years from today?
  • What are your sources of income currently?
  • What is your previous investment experience?
  • Have you worked with a financial advisor before?
  • What are your most crucial financial concerns?
  • What are your philanthropic goals?
  • What are your retirement goals?
  • What are your family and legacy goals?
  • What are your immediate goals?

The goal of financial advisors is to collect enough psychometric data while checking various signals and circumstances from investors. Since a qualitative approach can be very subjective, some financial planners use commercial tools that give quantitative data. While this technique may involve some questions, it relies more on mathematics to get risk scores and classify investors.

After the assessment, the financial planner classifies you into any of the following categories based on their findings.

1.    Aggressive

Aggressive risk-tolerant investors are tech-savvy and can handle more risk. They know the market well and have encountered large downwards and upward movements in their market portfolio in the past. If you are in this category, your risk tolerance is high. You may reap huge returns and risk big losses depending on market performance.  

2.    Moderate

Moderate risk investors adopt a balanced structure between safe and risky investments.  If you are in this category, you'll earn less but suffer relatively lower losses than aggressive investors based on market performance.

3.    Conservative

Conservative investors are willing to handle the least risk in their investments. Investors in this category settle for the safest options, and avoiding losses is their priority.


At Caldwell Trust, we understand investors differ in financial goals and the amount of risk they can tolerate. Therefore, we commit to giving our clients what we promise, including quality estate planning, retirement planning, and investment management services. Contact us today to learn more. 

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