Risk Tolerance as One of the Most Important Investment Categories

Risk tolerance is one of the most important parameters in investing, as it helps an investor perceive it as a routine part of daily life. It characterizes a person's willingness and ability to take risks and is usually described by three categories called risk profiles: risk-averse, risk-neutral, and risk-seeking. Choosing the right investment portfolio according to one's risk profile will save a lot of stress during periods of market panic or euphoria: an incorrectly defined risk level for a portfolio often leads to investment worries dominating all other concerns in a person's life.

A risk tolerance can be determined based on several factors representing key elements of the investor's current life situation and financial position. One of them is the investor's age, which defines the life horizon from the perspective of the ability to withstand short-term portfolio value declines. Another factor is the investor's financial reserves to cover portfolio losses using other assets. Important factors influencing risk tolerance also include current liabilities, such as the presence of dependents, debt burden, and upcoming major expenses. Finally, it is worth noting investor's risk appetite and their level of education in finance and economics.

IskraIndex offers a simple, impersonal test to estimate the investor's risk tolerance placed in your personal account. Given the fact that when registering on the website, an investor does not provide any information other than an email address, this test can be considered completely anonymous. However, this test cannot be an exhaustive indicator of a risk profile due to its anonymous nature and the overly narrow range of questions in the test's questionnaire. Choosing an IskraIndex model portfolio in accordance with the actual investor's risk profile will be the most adequate and rational solution in the investment process.

In terms of probability theory, each portfolio risk level indicates a probable range within which the portfolio's annual return is highly likely to fall. The narrowest range corresponds to a conservative risk tolerance while the widest corresponds to an aggressive one. Mathematics shows that over time, this range for all portfolio risk levels will narrow, converging around the portfolio's expected return. This serves as an argument in favor of long-term investing — any index portfolio will eventually converge to its expected return trajectory over time, and the risk level indicates how long an investor might wait for this to happen.

This again highlights the importance of selecting an appropriate model portfolio. An investor with a risk averse tolerance who chooses an aggressive portfolio may find that recovering from losses takes longer than they are willing to wait. Conversely, an overly conservative portfolio is not exposed to signifitant losses but may require more time to achieve the investor's target return for a risk seeking investor.