Barbara O’Neill, Extension Specialist in Financial Resource Management
Rutgers Cooperative Extension
Factors That Affect Investment Risk Tolerance
To help investors objectively assess their investment risk tolerance, Rutgers Cooperative Extension has an online Investment Risk Tolerance Quiz at www.rce.rutgers.edu/money/riskquiz
Developed by Dr. Ruth Lytton at Virginia Tech and Dr. John Grable at the University of Georgia, the quiz has 13 multiple choice questions and provides users with instant feedback about their capacity to handle investment risk.
The questions on the quiz are based on both thoughts about risk in hypothetical situations and current investing behavior. The higher a quiz taker’s total score, the greater the level of investment risk tolerance. Investors with a high risk tolerance are generally more comfortable than others keeping a large percentage of their portfolio in stocks (or stock mutual funds) and less likely to panic and sell during market downturns.
What factors determine investment risk tolerance? This question is the subject of much research. Women have often been found to be more conservative investors than men and people are generally less fearful in situations where they have some knowledge and/or experience. Below are factors that can affect investment risk-taking:
Emergency Savings- Investors with adequate cash reserves can handle more investment risk than those with meager emergency savings. An adequate emergency fund is an important pre-requisite for investing.
Investment Objectives- People with long-term financial goals, such as retirement savings, often invest more aggressively than those with short-term goals that require safety of principal.
Time Horizon- Investors with five to ten (or more) years until a financial goal have time to recoup a loss and can afford to invest more aggressively. Ditto for younger investors who have time on their side.
Net Worth- Investors can afford to take more risk when they have more assets. Investing your only $5,000 is very different than investing $5,000 when you have $100,000 more.
The Sleep Test- Conservative investors cannot stand as much anxiety related to the performance of their investments as aggressive investors and still be able to sleep at night.
Risk-Taking Propensity- Studies have found that people who are less inclined to take risks in daily life tend to choose conservative or moderate investments, while those inclined to take risks invest more aggressively.
Stock Market Performance- Studies have found that people tend to say they have a higher investment risk tolerance when the stock market is performing well and feel the opposite way during market downturns.
It is important to remember that there is no such thing as a risk-free investment. All savings and investment products have some type of risk. An example is purchasing power risk for cash assets, such as CDs and Treasury bills. Because they earn a relatively low taxable return, inflation can erode their value over time.
Another common type of investment risk, found in fixed-income investments such as bonds, is interest rate risk. This is the inverse relationship between bond prices and interest rates. When interest rates rise, bond prices fall, and vice versa. In a rising interest rate environment, investors can lose money if bonds are sold prior to maturity.
Stock investors face market risk, which is the risk that the price of individual securities will be affected by the volatility of financial markets. All sorts of factors can cause market volatility including low corporate earnings, political events at home and abroad and the release of government economic data.
Generally speaking, the greater the volatility of an investment, the greater its potential reward and the higher its risk. The key to successful investing is holding a diversified portfolio of low-cost investments over time.
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