Every investor has their own unique risk tolerance, referring to the amount of risk that they are willing to take in order to accomplish a specific level of investment return. In fact, there is an ideal investment return for any specific level of risk, otherwise called the Efficient Frontier. Understanding the relationship between risk and reward will help an investor to select the best portfolio and to have the most realistic expectations of its annual level of return.
Investors can often be categorized into one of 4 risk categories, aggressive, moderately aggressive, moderate and conservative. Each of these risk tolerance categories corresponds to investor characteristics such as time frame, expected return and investment objectives.
An aggressive investor is someone who is trying to out pace the S&P 500 Index, or targeting an annual return above 10-11%. An aggressive investor is often someone who is not seeking income, but who is seeking capital appreciation. Also, an aggressive investor is someone who has a time frame greater than 8 years. The investment mix of an aggressive portfolio will be heavily, if not entirely weighted towards equity investments.
Moderately Aggressive Investor
A moderately aggressive investor is someone who is trying to pace the S&P 500 Index, or who is targeting an annual return of 9-10%. A moderately aggressive investor is someone who is not seeking income, but who is seeking capital appreciation. The suggested investment time frame for a moderately aggressive investor is between 7-10 years and the investment mix is largely weighted to equity investments, although there is typically a small portion dedicated to fixed investments.
A moderate investor is someone who is targeting an investment return between 7-9% and is either someone seeking moderate investment growth or someone who is seeking current income. A moderate investor is someone who is often preparing for retirement, beginning to shift their focus from capital appreciation to capital preservation. The investment mix is often nearly equally weighted between equity and fixed investments. The suggested time frame for a moderate investor is typically 5-7 years.
A conservative investor is someone who is targeting an investment return well below the S&P 500 Index, or the average for the stock markets. A conservative investor is someone who is most commonly seeking a current income stream and who is more commonly concerned with capital preservation rather than capital appreciation. The expected yield of a conservative portfolio is between 5-7% per year, with the vast majority of investments falling in the fixed category rather than the equity category. The suggested time frame for a conservative investor is typically 1-4 years.
Understanding risk tolerance as it compares to the expected portfolio returns in an important concept to fully understand. For each given level of risk, there is a maximum expected portfolio return. This return is important for both reaching investment objectives as well as for generating required current income needs. Once an risk tolerance is chosen, individual investments will be chosen and managed over time to generate the desired or expected portfolio return over the investment time frame.