This article covers:

• What is Risk?

• Risk Capacity

• Risk Tolerance  

• Managing Your Risk

• Understanding Risk

“When markets change direction, things can unfold particularly quickly. This means investors should always be prepared for the possibility that a market downturn could result in a significant change in fortune in a short period of time. With this in mind, one of the most important concepts investors should be aware of is risk. It is ultimately at the heart of every single decision within the stock market, and the risk-reward trade-off is one of the most central themes that investors need to consider when investing in stocks.

we're here to help you understand risk tolerance, and how this might impact your approach to investing. 

What is Risk?

Risk is considered the possibility of suffering harm, loss, or danger'. 

In many facets of life, we encounter risk. We are prepared to accept some risks, whereas in other cases we are unwilling to accept other risks.

In the investing universe, this mantra is no different. Some investments come with greater risk than others, but may also offer greater upside in terms of potential returns.

When analysing stocks, the number of risks to consider are far-ranging. From regulatory changes, to exploration risk, reputational risk, macroeconomic factors, and a host of other possibilities, risk is fundamental to every investment decision.

However, unlike a number of other investment fundamentals, risk is a subjective field. There is no single way of measuring one tolerance for risk - in fact, risk operates on a relative scale, based on what we might call risk appetite'.

Risk Capacity

The clearest gauge with which investors can begin to analyse their risk appetite is by starting with their financial boundaries. In the context of financial risk, this is referred to as risk capacity. In other words, how much risk can you afford to bear?

Risk capacity is based on one individual circumstances, including your age, goals, assets, employment status, marital status, to name but a few metrics. It is different from risk tolerance, which We'll get to shortly.

Even though risk capacity may be personalised, there are still some general trends that typically apply. For example, a relatively young investor has more risk capacity than an older investor nearing retirement, or who has already retired. 

The younger investor has time on their side to compensate for any short-term volatility, and also time to build their net worth. On the other hand, the older investor can't afford to take on too much risk because they may depend on income to fund their retirement lifestyle, and any missteps at that point in life may not be recoverable.

Assets are another area where risk capacity is delineated quite clearly. An investor with more assets than they may need to fund their lifestyle has greater capacity for risk because market volatility would have less impact on their day-to-day living. But asset composition is key, because if all of an investor assets are tied up in investments, a market downturn can leave them exposed. In effect, they have low capacity for risk.

Risk Tolerance

While risk capacity sets the overall parameters for one potential risk appetite, risk tolerance is a gauge of your emotional values and attitudes when investing. If you have heard of descriptors such as risk-averse or risk-tolerant, these reflect one appetite for risk. In fact, your super fund follows a similar set-up, with different fund options for investors with different risk profiles.

The important thing to recognise here is that risk tolerance can, and often is very different to risk capacity. This is because our views and lived experiences shape our appetite for risk. If you have previously taken on too much risk, that experience may shape your attitudes towards the stock market.

Risk tolerance is something that can also evolve over time as our attitudes change. One of the most prolific indicators of this is when new investors enter during a bull market. They may generate high returns in a short period, with minimal effort, and with minimal risk. This experience could influence attitudes towards future investments, and as we all know, every bull market eventually comes to an end.

It is a similar story for those who start investing for the first time during a bear market. Sitting on paper losses may prompt caution when making future investment decisions, as risk tolerance could be lower due to past negative experiences.

Managing Your Risk

Thanks to the concepts of risk capacity and risk tolerance, investors can manage their investment risk by focusing on both areas.

First, risk capacity can be assessed by comparing one goals and cash flow requirements against their assets. This will help you form a rough idea of the level of volatility your portfolio can withstand.

Secondly, risk tolerance may be analysed through a series of questionnaires. Investors may be asked about their emotions and attitudes towards market volatility, money management, and broader risk acceptance.

As it is impossible to completely remove all risk, investors need to find an appropriate trade-off that strikes the balance between desirable returns and acceptable risk.

One of the most well-known strategies to manage risk is diversification. By spreading your money across a larger number of investments, ideally from different segments, you are reducing your risk. It all goes back to the saying, don't put all your eggs in one basket.

Of course, it also important to do your due diligence when analysing different stocks. While you may wish to hold some speculative holdings in your portfolio as satellite investments, these should ideally only represent a small portion of your capital, while your core investments are in less risky stocks. 

Read more about core and satellite investing here.

Understanding Risk

While there is no single-fit approach to risk tolerance, investors should always make sure they are cognisant of their risk tolerance, and make the necessary adjustments to ensure their portfolio is protected from excess risk. If you're unsure about your risk tolerance, it certainly helps to complete a risk profile analysis, as this will help you think through a number of hypotheticals around your attitudes to risk.