Risk tolerance is an investor’s capacity to handle the uncertainty that accompanies the selection of specific investment products such as stocks and bonds. For example, bonds are subject to interest rate risk (where bond prices fall as interest rates rise and vice versa), and stocks are subject to market risk (where general stock market trends affect the performance of individual securities). Risk tolerance has also been referred to as the “sleep at night factor,” as in “how much investment risk can you withstand and still be able to sleep at night?”
What factors determine investment risk tolerance? This question is still the subject of much research so there is no definitive answer. Not all factors related to investment risk tolerance are financial ones, however, such as income and net worth. An investor’s knowledge about investing, previous investment and business experience, and attitudes about risk-taking in general can also influence risk tolerance. In addition, risk tolerance levels associated with investments may be associated with other types of risk-taking behaviors in life such as fast driving and participation in extreme sports.
Rutgers Cooperative Extension has an online Investment Risk Tolerance Quiz available at http://njaes.rutgers.edu/money/riskquiz/. The quiz includes 13 questions and provides users with feedback about their capacity to handle investment risk. Data collected from users are also used for risk tolerance research. The higher the total score, the higher someone’s investment risk tolerance. Quiz questions are based on both thoughts about risk in hypothetical situations and current investing behavior.
Ideally, an investors’ risk tolerance level should remain about the same during bull and bear markets, although their investment asset allocation (i.e., the percentage of one’s portfolio held in stocks, bonds, and cash) will gradually get more conservative as they get older. However, this is often not the case. What happens, instead, is that investors’ risk tolerance levels are often greatly influenced by the current direction of benchmark market indices such as the Dow Jones Industrial Average.
Psychologists refer to the tendency for people to be sensitive to current information and feelings and to project current preferences onto future attitudes and behaviors as “projection bias.” A study conducted with data collected from the Investment Risk Tolerance Quiz examined the affect of stock prices of risk preference. It was determined that risk preference does, indeed, change in relation to stock prices and that recent stock market price changes have a great impact on subsequent risk preference levels.
In this study, an increase in previous week aggregate stock prices tended to increase risk preference levels in the following week. It appears that individual investors project current stock price trends into the future and determine their investment risk tolerance level accordingly. When market indices increased with increases in underlying stock prices, so did Investment Risk Tolerance Quiz scores and vice versa.
What if, after a period of stock price declines, you realize that your investment risk tolerance is not as high as you previously thought? First, realize that you are not alone, as this is a common situation experienced by many people. Below are six suggestions to bring your investment decisions in line with your true risk tolerance level:
• Increase your knowledge of investing to understand the risks involved.
• Place new investment money (e.g., future retirement savings deposits) in less aggressive investments.
• Consider selling stocks or stock funds that have under-performed market indexes for a year or longer.
• Avoid risky investments such as sector funds, aggressive growth funds, and penny stocks.
• Keep a long-term view and avoid reacting to daily investment performance indicators.
• Never invest in anything that you don’t fully understand or can’t explain simply to another person.
