TABLE OF CONTENT
- What is Risk Tolerance?
- 5 Factors That Influence Risk Tolerance
- What are the Levels of Risk Tolerance?
- Importance of Risk Tolerance in Bond Investments
Risk Tolerance: What is It In Relation To Bonds?
What is Risk Tolerance?
When an investor can handle the amount of loss while making an investment decision, it is called risk tolerance.
Investors who have a high source of income can afford to take more risks. Therefore, risk tolerance is among the crucial parts while investing in any type of asset, including bonds.
Knowing the risk tolerance, especially in bonds, will help you withstand potentially massive swings in the value of investments.
If an investor is taking more risk than their capability, they may fall into risk and sell investments at the wrong time.
Age is the primary factor in understanding risk tolerance, and it can be calculated by considering one’s investment horizon.
Generally, people who are young and starting their investment journey are encouraged to take more risks than other people.
Investing in equities, ETF’s or equity mutual funds has greater risk tolerance than others. However, investing in bond instruments like bond mutual funds possess lower risk tolerance.
5 Factors That Influence Risk Tolerance
- Time Horizon
- Financial Goals
- Age
- Portfolio Size
- Comfort Level
Every investor will opt for a different time horizon according to their investment plans. If an investor has more time, they can take more risk.
An individual looking for some money at the end of fifteen years can take more risk than an individual who needs the same amount of money by the end of five years.
Financial goals usually differ from investor to investor. The sole purpose of investors is not to earn the highest amount of money possible. However, the amount required to meet specific goals and an investment strategy to deliver such returns is usually pursued.
Therefore, every individual adopts different risk tolerance based on goals.
Young individuals tend to take more risks than older individuals because they have the passion and capability to make more money by working and have more time on their hands to handle all market fluctuations.
Portfolio size plays a crucial role in an investor’s life. The larger the portfolio means, the more tolerant it will be towards risk.
An investor with a one-crore portfolio will take more risk than an investor with a 50 lakh portfolio. If value declines, the percentage loss is less in a larger portfolio compared to a smaller portfolio.
Every investor handles risk differently. Some investors take more risk compared to others based on their comfort level.
Risk tolerance is directly related to how comfortable an investor can take risks easily.
What are the Levels of Risk Tolerance?
There are three different levels of risk tolerance involved:
- Aggressive Risk Tolerance
- Moderate Risk Tolerance
- Conservative Risk Tolerance
Aggressive Risk Tolerance
Aggressive risk tolerance is for experienced investors who have a deeper understanding of securities. The primary goal of these investors is to accumulate maximum returns through maximum risk taken.
Investors in this type of risk tolerance go for highly volatile instruments like options contracts which are small-cap stocks that can go zero to hundred and can flop in no time.
However, the primary investments of these investors is via equities because they are unable to balance the portfolio while investing in bonds.
Moderate Risk Tolerance
Here, the investors use balanced investments while taking some risk. The investment horizon is about 5 to 10 years. The investment horizon is estimated to be about 5 to 10 years.
The investors combine their bonds with large-scale mutual funds and pursue a 50-50 portfolio structure in equity VS debt instruments.
Conservative Risk Tolerance
Investors who are neither willing to take any type of risk nor accept volatility in their investment portfolio come under conservative risk tolerance.
These investors are retires who have invested their years in creating a nest egg that requires low risk to preserve. Their target instruments are generally secured bonds.
Investors also opt for several other saving-oriented investments like bank deposits or treasury investments that will help in the preservation of capital.
Importance of Risk Tolerance in Bond Investments
Bond instruments are generally of two types; secured bonds and unsecured bonds. The major difference between both bonds is the repayment risk.
As the name suggests, secured bonds refer to the safer option to park one’s funds than unsecured bonds. Unsecured bonds have a moderate risk tolerance profile that will find secured bonds more preferable than unsecured bonds.
Secured bonds offer collateral to several bondholders. If an issuer is not following the law on the payment of its principal amount, interest, or coupons to bondholders, a secured bond helps investors recover all their dues by liquidating the asset that is backing the bond.
Due to this high-level security, many investors prefer secured bonds as good investments because these types of bonds are suited for people with low investment risk.
On the other hand, investors do not get any type of security in the event of bankruptcy, leading to issuer default in unsecured bonds.
Investors select unsecured bonds depending on the creditworthiness of the issuer. However, investors with net income at their fingertips find unsecured loans a reliable option because of its higher risk tolerance.
FAQS
- Aggressive tolerance is for which type of investors?
- What is Risk Tolerance?
- Which factor influence risk tolerance the most?
Aggressive risk tolerance is for experienced investors who have a deeper understanding of securities. The primary goal of these investors is to accumulate maximum returns through maximum risk taken.
When an investor can handle the amount of loss while making an investment decision, it is called risk tolerance.
Time Horizon. Every investor will opt for a different time horizon according to their investment plans. If an investor has more time, they can take more risk.
An individual looking for some money at the end of fifteen years can take more risk than an individual who needs the same amount of money by the end of five years.
Final Thoughts
Before doing financial planning, estimating risk tolerance is crucial to get a clear idea of which investments one should make to boost the portfolio.
Risk tolerance changes according to the time, so one needs to keep being reassessed and updates. Risk tolerance, especially in bonds, can measure the ratio of secured vs. unsecured bonds one should invest in.
