Understanding Risk Tolerance and Why It Is Important

Property markets around the world are complex and ever-changing fields that not only serve as solutions in providing accommodation to billions of people but in making thousands of businesses and investors wealthy and profitable. Whether we will be looking at purchasing a flat as an investment to rent out or a barn conversion project that results in a number of living alternatives, investing in property has always been among the top choices for investors to focus on. Real estate investment can be a great source of ongoing income but can also be looked at as a long-term project for the bigger players.

Regardless of what the investor’s strategy is, property investment is a dynamic and constantly changing area that requires knowledge and expertise in order to be successful. To the inexperienced, the world of property investment may seem like a piece of pie that solely requires a rich bank account and a random choice of investment. However, the nature of investing is certainly not a gambling one and demands research, solid calculations, and a viable strategy.

Making an Investment

Experts have looked into the reasons behind property investment and have proved that it, in fact, is a good idea. Great news, you have now received approval and you are certain that this house or flat conversion project that you have set your eyes on is worth investing in! Let’s pause for a second and look deeper into the picture.

Just like anything else in life, if there is a valuable prize or treat at the end of the tunnel, it is likely that there will be obstacles or dangers on the way to the finish line – something that we call risk. If you think about it, risk is involved in our daily lives and we are so trained to quickly estimate whether an activity or decision is worth it that we sometimes even fail to acknowledge the thought-making process.

In the world of investing, the thought-making process is essential and it may even be demanded by other individuals involved in the investment such as employees, colleagues, accounting firms, or banks. One of the key ways to identify whether an investment should be made based on the related risk is risk tolerance.

Understanding Risk Tolerance

The risks of investing are varied and numerous. For example, investing in a certain property may not bring you the desired financial returns due to external factors influencing the price after a certain amount of time. For instance, currency fluctuations, developments or damages done to the area surrounding the property, or other economic factors can influence the price of the property and it may not be worth what it is today in five years, leading to losses for you as the investor.

To fully understand what risk tolerance is, we first need to look at its definition. Investopedia defines risk tolerance as “the degree of variability in investment returns that an investor is willing to withstand”. In other words, the concept is used to assess how much risk you are willing to tolerate without being severely hurt financially or having to lower your existing living standards.

Risk tolerance can be calculated for you by a professional property consultant or you can independently think about how it works for you as an investor or a business.

Estimating risk tolerance is also related to using a risk calculator or questionnaire, something that we will look into to provide more insight on the topic. By using risk tolerance, financial experts put investors in different categories, depending on their investment styles and the level of risk they are willing to handle.

Are Risk Tolerance and Risk Appetite the Same?

We have already discussed risk appetite in one of our blog posts with the aim of introducing readers and investors to the field of risk in investing. To recap, risk appetite was defined as the type and amount of risk an organization is willing to take. We acknowledged the fact that to truly make use of tools such as risk tolerance and risk appetite they should not be looked at in isolation, but should rather be analyzed together, forming a general picture of risk when it comes to investing.

In our article, we also looked at The Institute of Internal Auditors’ description of the difference between these two important factors. Both terms are used to establish boundaries in taking risk according to how much an organization or private investor has the capacity to accept. However, a risk appetite statement presents on a broader level the amount of risk management is willing to undertake, while risk tolerance presents a more narrow level of variation around different objectives.

For example, risk appetite would be when an investor or organization states that they are not ready to take on a risk that may result in a loss for the company. Risk tolerance would require the same organization or investor to state in more detail the risk it is not willing to tolerate, by using specific numbers and percentages. For instance, stating the risk tolerance could be saying that the company is not willing to take on the risk that may result in the loss of its production base of more than10%.

In basic words, risk tolerance is a more granular and detailed concept, relating to individual risks.

How to Calculate Risk Tolerance

If you have partnered with a financial planner or a property consultant for your next investment project, it is likely that they will discuss risk tolerance with your prior to making any decisions. If you have decided to take the journey alone and uncover the reality behind calculating risk tolerance, you could use a risk tolerance calculator that will certainly help with establishing how much risk you are actually willing to take.

Another method that can be used to establish your risk tolerance is a risk tolerance questionnaire. It is essential to answer the questions from the questionnaire in absolute honesty, taking into consideration the different scenarios provided. For example, a risk tolerance questionnaire may include questions like what your expectations are from this investment, considering that the market conditions remain stable. It may also put you in a scenario, in which the stock market suddenly starts performing extremely poor for the next ten years. What would your expectations from the investment be then?

Some of the key questions to consider when trying to understand your risk tolerance are:

  • For how long are you planning to invest?
  • How many years are you planning to work?
  • How do you react to a market high?
  • How do you react to a market low?
  • What are your expectations about the next three month’s performance of your investment?

You can find risk tolerance questionnaires online paid or free but it is advisable to consult yourself with a professional who will be able to provide feedback on the legitimacy of the questionnaire. This way, you will not be exposed to disappointments associated with reading your results incorrectly.

When to Use a Risk Questionnaire?

The purpose of the risk tolerance questionnaire is to help you understand your investment mentality better and think about the best and worst cases of your investment. It is also useful in establishing the category that you fall into depending on your risk tolerance levels.  The tool can be used when you are just starting your career as an investor to gain a preview of what your investment outcomes may be in general.

They can also be used for every project that you are willing to undertake in order to assess whether the risk tolerance fits in with your profit-making or growth objectives. The use of a risk tolerance questionnaire or calculator can be a lifesaver when it comes to avoiding making unnecessary risks or making severe financial losses that may put your future or the future of your business at risk.

However, the use of risk tolerance calculators or questionnaires may not be fully sufficient for the development of a realistic view. Risk tolerance can also be based on psychometrics, emotional, and other behaviors that may influence an individual’s trigger to take a risk. Working with a professional expert that is qualified in the field of risk management and risk assessment will expose you to a wider range of alternatives to use in order to establish risk tolerance.

Risk Tolerance Types

We already mentioned that there are different types of investors depending on their risk tolerance. There are separate categories of risk tolerance and investors who fall under a certain category share traits related to risk-taking with other investors from the groups. Let’s take a look of the most commonly seen risk tolerance types!

Aggressive Risk Tolerance

Aggressive risk tolerance is typical for aggressive investors, who have evident experience in their chosen market and usually have a substantial financial wealth to back-up their investments. They will usually know their stuff inside-out and will not show much vulnerability or uncertainty towards an investment.

Aggressive investors usually pursue highly unpredictable or volatile instruments or property projects, meaning that they often have a portfolio with the highest returns but hold higher risks of failure. These types of investors go all-in in their investment strategies and have a high investment tolerance as they can cope with more risk than others.

Moderate Risk Tolerance

The investors with a more balanced approach to investing are considered moderate investors and fall in a category where the time horizons are between five to ten years. Moderate investors are those that will never invest all their funds in a single project but will rather try to spread their risk 50/50, ensuring that there is some profitability if their objectives are not met and their initial plan results in failure.

Most investors fall under this category as they strive for good returns but also acknowledge that there is some risk involved in the investment. Investors with moderate risk tolerance will probably invest in moderate growth options, for example, where there is a combination of different investments to be made.

Conservative Risk Tolerance

This is where the beginners usually start from. Conservative investors are willing to take little to no volatility in their investments and their portfolios are usually only safe and secure ones that are most unlikely to fail. The desired returns are low but are at the price of keeping risk at minimum levels. If we look at an ordinary person looking to invest we could describe them as someone of an age close to retirement, who is not looking to sacrifice his life savings for a risky investment.

To conclude, it is safe to say that making investment decisions is surely not an easy process and it involves a lot of thought, analysis, and calculation in order to provide the best possible results. By opening up the territory of risk tolerance and risk appetite, you can be more confident about the investment decisions that you choose to pursue and maximize the change of receiving high returns of your investment.

Choosing to work with a professional expert familiar in the field will certainly save time and stress in trying to understand the complex nature of investing. Experience property consultant investments fro the Seed Property Group can help you achieve your investing goals and ensure a smooth and easy process that will help you grow as an investor.

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