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Investors with different levels of risk tolerance are more satisfied with investment strategies that are better aligned with their risk preferences.
Differences in investors’ personal risk tolerances mean that more risk-averse investors are personally more satisfied with a lower risk portfolio despite its lower expected returns. Less risk-averse investors are more satisfied with portfolios characterized by higher risk and higher expected returns.
When defining a personal investment strategy and before making related decisions, it is important for individuals to assess their personal risk tolerances relative to other investors. Investing involves risk, and there is no way around it. Investing means that the investor is willing to incur risk in exchange for the possibility of a higher payoff. An investor’s relative risk tolerance is the primary decision in his asset allocation strategy.
Individuals are not investing, unless there is a chance to lose some of or the entire price paid for a security. Rational investors expect increased returns for taking on increased risk.
True investors are all assumed to be risk-averse versus risk-seeking. Market prices of securities reflect the current risk consensus, and investors have rational expectations for positive risk-adjusted payoffs. Investing is not like traditional gambling, where the expected average payoff is negative.
Differences in risk tolerances mean that more risk-averse investors are personally more satisfied with a lower risk portfolio despite its lower expected returns. Less risk-averse investors are more satisfied with portfolios characterized by higher risk and higher expected returns. Investors with different levels of risk tolerance are more satisfied by the expectations associated with investment strategies that are better aligned with their risk preferences.
Everyone would like higher returns, but only some are able and willing to live with the greater risks that are associated with a potential for higher returns. However, there are no guarantees in investing. All apparent “guarantees” themselves have a price and risks.
Because investing is inherently risky, individuals should understand their probable response to risk factors that actually do materialize. Risk tolerance is an issue of personal psychology and will determine whether an investor will adhere to and sustain an investment strategy during difficult times. When markets are performing poorly and fears are high, an inappropriate alignment between an individual’s personal portfolio risk or volatility and his or her tolerance for that risk [...]