Risk Tolerance - Meaning and Significance

Learn all about risk tolerance which is an investor's ability to endure market volatility and uncertainty while pursuing investment goals.
Risk Tolerance
3 min
29 March 2024

It is no secret that the securities market is subject to fluctuations based on a variety of factors. As a result, all market-linked investments carry a certain degree of risk; while some instruments carry high volatility and high risk, others are relatively less volatile and, therefore, less risky. An investor has to consider several factors while selecting an investment instrument for their portfolio, one of which is risk tolerance.

What does risk tolerance mean?

Risk tolerance is the magnitude of the risk an investor is willing to undertake during the course of an investment. Let us understand what is risk tolerance with the help of a simple example. Investor A wishes to invest Rs. 10,000 in the securities market for two years. One of the main criteria they are concerned about while selecting an investment avenue is the degree of risk.

The maximum loss A is willing to expose their portfolio is 10%, that is, Rs. 1,000. Therefore, they end up choosing an investment option that has a historical record of less than 10% loss. Risk tolerance is, thus, one of the primary factors that drive the selection of an investment instrument. Having clarity on one's risk tolerance helps an investor select the right investment options, and also enables them to restrict their potential loss (subject to market volatility).

Factors affecting an investor's risk tolerance

Different investors have varying degrees of risk tolerance. While some investors are open to assuming a high degree of risk in the hopes of high returns on their investment, others are risk averse and wish to protect their principal investment to a certain degree. There is a wide array of factors that have a bearing on an investor's risk tolerance, prominent amongst which are:

  1. Income: Since an investor's capacity to invest is directly dependent upon their earning capacity, their income has an impact on their risk tolerance. Investors with high income and large savings can be open to assuming a high degree of risk, whilst those with low income and savings may be risk averse.
  2. Investment timeline: Another key factor affecting an investor's risk tolerance is the timeline of their investment. Investors with a long term investment horizon may be willing to undertake a high degree of risk, thinking that the impact of market volatility shall be somewhat neutralised over a long period. In stark contrast, investors with a short term investment horizon may have a relatively lower risk tolerance.
  3. Size of the portfolio: The larger and more varied an investor's portfolio of investments, the higher their risk tolerance is likely to be. This stems from the balancing of risk across various asset classes. An investor with a smaller portfolio, on the other hand, may be risk averse.
  4. Availability of alternate assets: If an investor has alternate assets that add stability to their financial standing, for instance, home, car, rental income, etc., they may have a high risk tolerance when it comes to investments. An investor who has no or very few alternate assets may find it difficult to undertake high risk in their market-linked investments.

Types of investors based on their risk tolerance

Depending upon their risk tolerance, investors can be classified into three categories, namely, aggressive investors, conservative investors, and moderate investors.

  1. Aggressive investors: Investors who have a high risk tolerance are termed as aggressive investors. Such investors are generally willing to assume high risk in their investment choices with the potential payoff of a high return. Aggressive investors tend to invest in high-risk and high-return assets, for instance, equity shares.
  2. Conservative investors: Investors who are unwilling to assume a high degree of risk in their investments are termed as conservative investors. Such investors are satisfied with restricting their return on investment as long as their risk exposure remains within the desired limits. Amongst the asset classes preferred by such investors are debentures, bonds, and government-backed securities.
  3. Moderate investors: Investors who wish to walk the fine line between undertaking risk and protecting their principal investments are termed as moderate investors. Such investors usually opt for a diverse and balanced portfolio so as to attain an optimal balance between risk and return. Moderate investors tend to invest in a combination of equity shares, debentures, mutual funds, money market instruments, etc. Their portfolio allocation is usually 60/40 in or 50/50.

What is a 60/40 Portfolio?

A 60/40 portfolio is an investment portfolio with 60% allocation to equity-based instruments and 40% allocation to debt-based instruments. Considered to be an optimal portfolio for investors with moderate risk tolerance, such an investment portfolio offers a fine balance between risk and return.

Let us understand a 60/40 portfolio with the help of an example. Investor B wishes to create a 60/40 portfolio for an investment of Rs. 20,000. Their aim is to balance capital appreciation and investment protection. Therefore, they add equity stocks worth Rs. 12,000 in their investment portfolio and fixed-income government-backed securities worth Rs. 8,000. Whilst the investment in equities offers high potential for return, the investment in debt securities adds a layer of stability to the portfolio.

Financial products with high risk tolerance

Since your risk tolerance is an important factor driving your selection of investment instruments, it is pivotal to understand which financial instruments carry high risk. Equity stocks and bonds are generally considered the most high risk investment options owing to their high degree of volatility. Should you wish to invest in high risk investment instruments, you can subscribe to an Initial Public Offering (IPO) or purchase the shares of a listed company from a stock exchange.

Difference between risk tolerance and risk capacity

It is important to understand that there is a fine distinction between your risk tolerance and risk capacity. Whilst the former is a barometer of the amount of risk you are willing to expose your investments to, the latter signifies the quantum of risk you can afford to assume without jeopardising your financial objectives. Risk tolerance can, therefore, be described as a subset of risk capacity.

You can check out various mutual fund schemes and select one or more which meets your investment needs on the Bajaj Finserv Mutual Fund Platform. Browse over 1000+ listed mutual funds, compare funds, and choose the scheme based on your risk tolerance and investments goals.

You can also use our SIP calculator to compute the monthly contribution you need to make to the selected mutual fund.