Most people have at some point in their lives stopped to ask themselves how risky something is. Whether it is skydiving, skiing, and even walking, an individual’s comfort level will determine their next step. Risk tolerance regarding investing is very much the same. Investors will determine how comfortable they are with the idea of potentially losing all of their money for the chance of a probable return greater than the amount they initially invested.
Measuring and determining your risk tolerance is the first step to take before choosing the best investments for your financial goals. Once you know how much market risk you can tolerate, you can choose suitable investments with an appropriate strategy.
Factors that determine an investor’s risk tolerance are:
- Timeline: Each investor will adopt a different timeline based on their investment plans. Generally, more risk can be taken if there is more time. An individual who needs a certain sum of money at the end of fifteen years can take more risk than an individual who needs the same amount by the end of five years. It is due to the fact that the market has shown an upward trend over the years. However, there are constant lows in the short term.
- Goals: Investment goals differ from individual to individual. Therefore, each individual will take on a different risk tolerance based on goals.
- Age: Generally, young individuals should be able to take more risks than older individuals. Young individuals have the capability to make more money through working and have a longer investment horizon to handle market fluctuations.
An investor’s risk tolerance can be measured using a comfort scale such as:
- Aggressive Risk investors are well versed with the market and take larger risks. Such types of investors are used to seeing large upward and downward movements in their portfolio. An aggressive investor wants to maximize returns by taking on a relatively high exposure to risk. As a result, an aggressive investor focuses on capital appreciation instead of creating a stream of income or a financial safety net.
- Moderate Risk investors are relatively less risk-tolerant when compared to aggressive risk investors. They take on some risk and usually set a percentage of losses they can handle. They balance their investments between risky and safe asset classes. With the moderate approach, they earn less than aggressive investors when the market does well, but do not suffer huge losses when the market falls.
- Conservative Risk investors take the least risk in the market. They do not indulge in risky investments at all and go for the options they feel are safest. They prioritize avoiding losses above making gains. Investing conservatively is not about simply identifying large, well-known businesses, but also going through a process that identifies why a particular company qualifies as a conservative investment.
Examples of Investment Risk
Investment risk is the chance that an investor will experience a decline in returns, due to factors that are outside of the investment itself. These are generally factors beyond the control of an individual investor, and examples include:
- Economic risk is the likelihood that an investment will be affected by macroeconomic conditions, such as government regulation, exchange rates, hyperinflation, or political stability, most commonly involving strong foreign relations between countries in North America like Canada and the U.S.
- Political risk is the risk an investment’s returns could suffer as a result of political changes or instability in a country. There are a variety of decisions governments make that can affect individual businesses, industries, and the overall economy. Some of the political risks may be found in a company’s filings with the Securities and Exchange Commission (SEC) or a prospectus if it is a mutual fund.
- Social risk is an event that influences an investment portfolio that may include a culture shift away from the use of particular products. Examples of social risks include the use of fur and animal testing in fashion and cosmetics, as well as the growing interest in eco-friendly and renewable products.
- Event risk is when something happens to a company that has a sudden impact on its financial condition. This generally includes an unexpected or unusual event, such as the sudden death of Micron Technology’s CEO, Steve Appleton in 2012, when the company and technology industry was left stunned. Micron’s stock price sank.
- Liquidity risk involves not being able to sell an investment quickly enough. This usually includes price volatility, where the value of an investment may be dropping very fast. When it comes to cash, the risk of a banking institution running out of money while trying to meet an increased demand in withdrawals is known as a run on the bank.
Investment risk ultimately will be the measure between what you would lose versus what you could potentially gain – your risk and reward.
Most investors associate duration risk with bonds and fixed income. Duration measures the price sensitivity over a period of time. If an investor purchases a Certificate of Deposit (CD) at their local bank, the investor is agreeing to lend, or invest in, the bank money through the purchase of a CD in return for interest, plus the original principal at a later date. The CD price will change in value if interest rates were to rise or fall. The longer the duration, the more sensitive a fixed income investment will be, which is reflected in changes to interest rates.
Investors may plan to invest in a product, such as stocks, over a long period of time, but may find themselves in an emergency situation that would require them to sell an investment prior to its expected holding period. Examples include job loss, illness, or other life events.
Duration risk can appear as an unintended consequence from market changes that prevent an investor from being able to sell. This particular risk is common in private equity and real estate investment trusts where a change in real estate demand or increased supply in a market could affect an investor’s ability to cash out.
Duration risk requires an investor to consider the tradeoffs involved regarding each investment and the “what if” scenarios that could take place throughout a given period.
Insurance products, such as annuities, also tend to carry a good amount of duration risk. Investors purchase annuities and other insurance products as a hedge to prevent a full loss. Investors pay a premium if the event being covered occurs, and the insurance policy will pay the investor a predetermined amount. On the flip side, an investor could pay thousands of dollars in premiums towards a policy that is a mismatch in terms of their liabilities and assets.
Tax risk is the chance that the local or federal government, through Congress, will make a change to the tax laws that may affect your investment portfolio or individual tax situation. Tax changes that influence investment portfolios are:
- Tax law changes that eliminate or reduce exemptions
- Limited tax deductions
- Increases in tax rates
The main provision of the Tax Reform Act of 1986, signed into law by U.S. President Ronald Reagan, taxed capital gains at the same rate as ordinary income and was capped at 28%. This act attracted many new investors to capital markets. The Taxpayer Relief Act of 1997 took the capital gains tax down to 21.2% for investors.
The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced capital gains temporarily to 15% for investors on qualified dividends and long-term capital gains. This law received several extensions through 2012.
More recently, tax laws regarding long term capital gains are capped at 20%. Long term is considered to be any investor who holds a particular stock, bond, or other investment described in the tax law for at least one year.
All investments are vulnerable to tax risks; however, the following investment products are the most sensitive.
- Municipal Bonds: An investor will want to consider the state or government issuing the bond for tax favorable status, such as an investor’s state of residency.
- Real Estate: Depending on what an investor’s goals are for purchasing real estate, they may need to consult a tax professional to determine the best strategy.
- Natural Resources: Tax laws that regulate utility pricing have an effect on natural resources. An increase in taxes for natural resources may be in response to negative unintended environmental effects and a way to manage the growing costs of economic consumption.
- Foreign Investment: When Americans buy stocks or bonds from a company based overseas, any investment income including interest, dividends, and capital gains are subject to U.S. income tax. Here’s the kicker – the government of the company’s home country may also take a slice.
Deflation risk is when consumer and asset prices decrease over time, and purchasing power increases. Essentially, you can buy more goods or services tomorrow with the same amount of money.
Deflation risk may actually seem like a good thing, when we consider how nice it is to get things on sale. As an investor, it can signal an impending recession and hard economic times. When people feel prices are declining, they delay purchases in the hopes that they can buy things for less at a later date. However, lower spending leads to less income for producers, which can lead to unemployment and higher interest rates in the longer term.
The negative impact of deflation leads to prolonged periods of lower prices that historically have led to higher unemployment and even lower prices, with even less spending. There are two main culprits for deflation risk:
- Decline or decrease in demand
- Growth or increase in supply
Throughout most of U.S. history, periods of deflation usually go hand in hand with severe economic downturns. Often, deflation risk can be described as a deflationary spiral.
Inflation risk is the opposite of deflation risk. Inflation commonly refers to how the prices of goods and services increase more than expected. The same amount of money invested will result in less purchasing power. Inflation risk is also known as purchasing power risk.
As an investor, it is important to understand the impact of inflation. If you are lending money at a higher interest rate, you will earn more interest during times of inflation, and this may be good for your investment strategy. If you are borrowing money, you are paying a higher interest rate, therefore increasing your costs and reducing your potential rate of return.
Inflation risk tends to have the highest influence over investments that are directly tied to interest rates, such as:
- Real estate
- Foreign currency exchange
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