What Is Risk Tolerance?

Definition

Risk tolerance is the degree of uncertainty or volatility an individual or organization is willing to accept in pursuit of their financial goals, a concept closely related to Harry Markowitz's Modern Portfolio Theory, 1952.

How It Works

Risk tolerance affects investment decisions by influencing the allocation of assets in a portfolio. According to the Capital Asset Pricing Model (CAPM), investors demand a higher return for taking on more risk, which is reflected in the beta of a stock. For instance, an investor with a high risk tolerance may allocate a larger portion of their portfolio to high-beta stocks, such as those in the technology sector, which have historically been more volatile than the overall market. Boeing produces ~800 aircraft annually (Boeing annual report), and investors in the company's stock must be willing to accept the risks associated with the aerospace industry, including fluctuations in demand and regulatory changes.

The risk tolerance of an investor also determines their willingness to hold onto an investment during periods of market volatility. Investors with a low risk tolerance may be more likely to sell their assets during a downturn, realizing a loss, while those with a higher risk tolerance may be more likely to ride out the storm, potentially benefiting from a recovery in the market. The Sharpe Ratio, developed by William Sharpe, 1966, provides a measure of the excess return of an investment over the risk-free rate, relative to its volatility, allowing investors to evaluate the risk-adjusted performance of their portfolio.

Investment managers use various techniques to assess an individual's risk tolerance, including questionnaires and risk assessments, to determine the optimal asset allocation for their clients. The efficient frontier, a concept introduced by Markowitz, 1952, represents the set of optimal portfolios that offer the highest expected return for a given level of risk, and investment managers use this framework to construct portfolios that align with their clients' risk tolerance. For example, an investment manager may use the Black-Litterman model, developed by Fischer Black and Robert Litterman, 1990, to combine the investor's prior beliefs about the market with the historical returns of the assets, resulting in a more informed asset allocation decision.

Key Components

• Risk capacity: the amount of risk an individual or organization can afford to take, based on their financial situation and goals, which increases as their wealth and income grow.
• Risk perception: the subjective assessment of risk, influenced by personal experiences, emotions, and biases, which can lead to inconsistent investment decisions if not properly managed.
• Investment horizon: the length of time an investor has to achieve their financial goals, which affects their risk tolerance, as a longer horizon allows for more risk-taking due to the potential for higher returns over the long term.
• Diversification: the strategy of spreading investments across different asset classes to reduce risk, which is essential for managing risk tolerance, as a diversified portfolio can provide more stable returns over time.
• Expected return: the anticipated return on an investment, based on historical data and market expectations, which is a critical component of risk tolerance, as investors must balance their expected return with their willingness to accept risk.
• Volatility: the degree of uncertainty or fluctuation in the value of an investment, which is a key factor in determining risk tolerance, as investors must be willing to accept a certain level of volatility to achieve their financial goals.

Common Misconceptions

Myth: All investors should aim to maximize their returns, regardless of risk — Fact: Investors with a low risk tolerance, such as retirees, may prioritize preserving their capital over maximizing returns, as evidenced by the life-cycle hypothesis, developed by Franco Modigliani and Richard Brumberg, 1954.

Myth: Risk tolerance is constant over time — Fact: Risk tolerance can change over time due to changes in personal circumstances, such as marriage, divorce, or retirement, which can affect an individual's financial situation and goals.

Myth: Investors with a high risk tolerance always earn higher returns — Fact: While investors with a high risk tolerance may earn higher returns over the long term, they also face a higher risk of losses, as seen in the 2008 financial crisis, when many investors with high-risk portfolios suffered significant losses.

Myth: Risk tolerance is the same as risk capacity — Fact: Risk tolerance refers to an investor's willingness to accept risk, while risk capacity refers to their ability to absorb losses, as illustrated by the Bernstein's risk questionnaire, which assesses an individual's risk tolerance and capacity.

In Practice

The Norwegian Government Pension Fund Global, with assets over $1 trillion (Norges Bank Investment Management), has a long-term investment horizon and a relatively high risk tolerance, which allows it to invest in a diversified portfolio of stocks, bonds, and real estate. The fund's investment strategy is guided by the Markowitz's Modern Portfolio Theory, 1952, and the Black-Litterman model, 1990, to optimize its asset allocation and balance its expected return with its risk tolerance. By taking a long-term perspective and maintaining a diversified portfolio, the fund has been able to achieve stable returns over time, while managing its risk exposure to meet its financial goals.