What is Risk tolerance determination?

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The concept of managing risk goes back almost 2 thousand years when humans started playing games of chance. However, in today’s world risk management has become an essential component of strategic planning. In order to start the process of managing risk, one must first ask the question, “what risks am I willing to take?” or in other words “what is my risk tolerance?”

Risk tolerance refers to the degree of variability towards investment returns or losses that an investor can withstand. It is considered an important component of investing because, through it, an investor can understand his willingness and ability to analyze the value of his investments or decisions. The variability that is involved in risk tolerance refers to the extent to which available data points can be measured and evaluated. In determining variability, four measures are commonly used: mean, range, standard deviation, and variance. These measures are good indicators for determining the risk tolerance of a person based on statistical data. In the business and in life, we often equate these measures in terms of predicting probable outcomes based on various choices.

Risk tolerance determination involves tests that measure investors’ risk tolerance in order to assess how they react to varying kinds of risks. It must be noted, however, that the determination of one’s risk tolerance is not an exact science. The tests in determining risk tolerance are not foolproof since the psychological behaviors of people can change under varying conditions. Tests for determining risk tolerance are only designed to give people a general sense of how much risk they can accept. Nevertheless, the results are usually regarded as reliable.

Investment risk is often the main subject of any risk tolerance determination. In the world of investments, risk refers to the uncertainty and possibility that an investor will lose some or all of his investment, or that the investment will yield less than the anticipated return. Because of the uncertainty of the return of an investment, investment risk also refers to how an investment’s price changes or fluctuates in value over a period of time. As the fluctuation in amount and frequency becomes greater, the volatility of the risk becomes greater as well. And if the volatility of risk becomes greater, the uncertainty of the outcome of investment also becomes greater.

This rationale can also be applied to business decisions being contemplated by entrepreneurs, the management or a Board of Directors. Instead of relying on “gut” or wild unsubstantiated predictions, businesses need to obtain and analyze data that is often provided by financial professionals.

Contrary to what you may think, the smaller the organization, the more important it is to know your risk tolerance and have procedures in place to test that tolerance.

Two Types of Risk Tolerance Tests

Risk tolerance tests generally have two categories: psychological tests and investment preference tests. A psychological test involves an elaborate questionnaire that attempts to measure a person’s attitude and reaction to risk. This kind of test typically includes questions about the behavior of feelings of a person or business owner, or it can ask a person to respond to certain hypothetical situations. This kind of testing is convenient to use, as it can be fun and enjoyable to take. A disadvantage, however, is that people like to regard themselves as risk takers and they may not answer the questionnaire as accurately as expected. Eventually, they find out during their first downturn that they are really risk-averse than they originally thought.

The second category is the investment preference test. This involves a questionnaire that tests the preferences of a person for selected investment vehicles. The questionnaire asks about the person’s current goals, financial situation, and past investment experiences. This test is relatively easy to conduct and is simple as well. The disadvantage of this test, however, is that it does not gauge accurately the person’s propensity for risk-taking because it does not cover the emotional reactions of a person to different risks.

Factors Affecting Risk Tolerance

In determining risk tolerance, several factors can affect the person or organization’s tolerance. The most important factor perhaps is the time frame for a positive outcome. It is common knowledge that a younger investor has a longer timeframe for investment and can take on more risk. For long-term investments, there are more chances for aggressive investing. The also applies for business decisions. Start-ups may be more aggressive than a more mature organization that has spent years developing a brand or cultivating stakeholders. Another factor is the risk capital, which is the money available for investment and should not affect the investor’s lifestyle should he lose it. It makes a huge difference if the new venture or program is being funded through available working capital or if a separate funding source is available.

Finally, the experience or history of the person or organization is also important because this can affect the organization’s commitment to the investment or project.