Risk tolerance is a limit on the aggregate risk in a portfolio or the risk in a single transaction. Ensuring risks are within acceptable limits is best achieved if risk tolerance is quantified. Since risk tolerance is subjective, quantifying it and then 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 quantified 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. Completely 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 25% of your net worth in a deal that had a 75% chance of being very profitable, how would you feel about that investment?
A. No level of profit would be worth that kind of risk.
B. The profit potential would have to be five times the investment.
C. The profit potential would have to be three times the investment.
D. The profit potential would have to be twice my investment.
5. If an investment you made doubled in value in one year, what would you do?
A. Take the money
B. Liquidate half the position
C. Let it ride
D. Invest more
6. How would you feel if the market fell 30% in a month, reducing the value of your portfolio from $100,000 to $70,000?
A. The thought makes me sick.
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 risk.
13 to 20: Moderate risk tolerance; you are comfortable with reasonable risk.
21 or above: High risk tolerance; you are willing to take high risk for potentially high returns.
Ponder this ... do you think your personal risk tolerance is higher or lower than your company's? If your company is taking more or less risk than you would, are you working in the right place?