What Is Risk Tolerance?
When it comes to your finaHowever, age alone should not determine switching asset classes. Individuals with a higher net worth have more disposable income and can afford to take more risk, despite their lower investment horizon. Hence, age is just one factor among many that can help gauge how much risk is ideal to take on in oncial planning, the degree of variability you are willing to handle in your investments is referred to as your risk tolerance. Risk tolerance is among the most crucial components when one is investing in any type of asset, including bonds. Knowing how much risk tolerance in bonds you can withstand will help stomach any potentially massive swings in the value of your investments. If you take on more risk than you are comfortable with, it’s possible you may panic and sell your investments at the wrong time.
Age is important for understanding risk tolerance, meaning it can often be calculated by taking one’s investment horizon into consideration. Generally, people that are just starting out their investment journey and are younger are encouraged to take on more risk than older individuals who are restricted to a shorter investment horizon. Greater risk tolerance is often synonymous with investing in equities, ETFs, or equity mutual funds. Lower risk tolerance is usually associated with investing in bond instruments like bond mutual funds and ETFs.
Levels of Risk Tolerance
In a general sense, risk tolerance can be divided into three levels: aggressive, moderate, and conservative. The investment portfolios of each of these three levels of risk tolerance would look like this:
Aggressive Risk Tolerance: Market savvy investors with a deep understanding of securities. The goal is to reach maximum returns through maximum risk taken. Tend to go for highly volatile instruments like options contracts which may worthlessly expire or small-cap stocks that can skyrocket or flop. Bond investments may be unsecured to balance one’s portfolios, but the primary investment is via equities.
Moderate Risk Tolerance: Approach to investments is balanced with some risk being taken. The investment horizon is estimated to be about 5–10 years. Investors may combine bonds with large scale mutual funds and pursue a 50–50 portfolio structure in equity vs debt investments.
Conservative Risk Tolerance: Such investors are not willing to accept volatility in their investment portfolios. Often, these are retirees who have used their formative years to create a nest egg which requires as little risk as possible to preserve now. They target instruments such as secured bonds. They also go for bank deposits, treasury investments, and more such savings-oriented investments that will aid in the preservation of capital.
Significance of risk tolerance in bond investments
Broadly, there are two types of bond instruments: secured bonds and unsecured bonds. The fundamental difference between these two types of bonds is the risk of repayment. As its name suggests to even a novel investor, secured bonds have a reputation of being the safer option to park one’s funds relative to unsecured bonds. Anyone with a low to moderate risk tolerance profile will find secured bonds preferable to unsecured bonds.
Secured bonds offer collateral to bondholders. In the scenario in which an issuer defaults on the payment of its principal amount, interest, or coupons to bondholders, secured bonds allow for investors to recover their dues by liquidating the asset that is backing the bond. Due to this security, investors consider secured bonds good investments even at low rates of interest. Hence, these types of bonds are suited to people with lower appetites for risk in their investments.
With unsecured bonds, investors no longer have any kind of security in the event of bankruptcy leading to issuer default. Investors choose unsecured bonds based on the credit-worthiness of the issuer. One needs to have proper tools at their disposal to assess this creditworthiness. However, individuals with more disposable income at their fingertips, and a higher risk tolerance tend to find unsecured bonds are a superior option.
Before financial planning begins, assessing risk tolerance is crucial to get an idea of which investments should make up the bulk of one’s portfolio. Risk tolerance changes with time so it needs to keep being reassessed and updated. Risk tolerance in bonds can help determine the ratio of secured vs unsecured bonds one should invest in.