Typically, risk tolerance is a limit on the aggregate risk in all open transactions in a portfolio. It may also apply to individual transactions. Ensuring risks are within acceptable limits is best achieved if risk tolerance is quantified. Since risk tolerance is subjective, quantifying it and applying it can be difficult. That’s where a measure called Value-at-Risk (VAR) is helpful. VAR yields a dollar figure for the worst case loss in the value of a position or portfolio within a specific time and confidence level (e.g. one year and 95%). A limit on VAR equates to risk tolerance.
Personal Risk Tolerance
(Scoring: A – 1, B – 2, C – 3, D – 4)
1. How do you make investment decisions?
A. Never on my own
B. Sometimes on my own
C. Often on my own
D. Totally on my own
2. As an investor, how do you rate yourself?
A. Terrible
B. Average
C. Above average
D. Exceptional
3. You think investment success is mainly due to:
A. Fate
B. Being in the right place at the right time
C. Taking advantage of the right opportunities
D. Hard work and careful analysis
4. If someone offered to invest 15% of your net worth in a deal that had an 80% chance of being profitable, how would you feel about making that investment?
A. No level of profit would be worth that kind of risk.
B. The profit potential would have to be seven times the amount I invested.
C. The profit potential would have to be three times the amount I invested.
D. The profit potential would have to be twice my original investment.
5. If an investment you made doubled in value in one year, what would you do?
A. Liquidate all of it
B. Liquidate half
C. Do nothing
D. Invest more
6. How would you feel if the market fell 30%, reducing the value of your portfolio from $100,000 to $70,000?
A. The thought makes me ill.
B. I could handle it, but would rather avoid such a nasty situation.
C. It would not be the end of the world, since the market “corrects” from time to time.
D. It would be a great time to buy, since the market always bounces back.
12 or less: Low risk tolerance; you are uncomfortable taking risks.
13 to 20: Moderate risk tolerance; you are comfortable with reasonable risks.
21 or above: High risk tolerance; you are willing to take risks in search of high returns.
Something to think about ... does your risk tolerance match your employer's?