Two terms that you’re likely to encounter often in your investment journey are risk appetite and risk tolerance. Many make the mistake of interchanging the two on the assumption that they mean the same thing.
But while both risk tolerance and risk appetite pertain to the degree of uncertainty that comes with an investment, and while the two are definitely interrelated, they are not the same thing. Moreover, the ideas of risk appetite and risk tolerance vary from person to person. One investor’s benchmark for their risk appetite may be much larger compared to another’s, and the same applies to risk tolerance.
What distinguishes risk appetite from risk tolerance, and how can an investor arrive at a particular numerical equivalent for either of the two? Here’s how to tell the difference, plus some advice on determining risk appetite and risk tolerance benchmarks for an investment like Monero (XMR) cryptocurrency stored in a Monero wallet.
Risk Appetite: A Metric for Meeting Financial Objectives
The first concept that you should understand as a fledgling investor is risk appetite. In simple terms, risk appetite pertains to the measure of how much risk an investor is willing to take on in order to achieve their goals.
In the field of enterprise management, a company’s risk appetite is documented and disseminated to its stakeholders, or those who’d bear the brunt of the risk in case of financial loss. Though you’re not obligated to do this if your investment is yours and yours alone, it would be good to take a leaf from the books of major enterprises and ascribe an exact number or amount to your risk appetite.
It’s important to determine your personal risk appetite so that you know exactly what it will take to get the returns you want, plus how you’ll get there. Your risk appetite serves as your basis for granular risk management strategies to be applied to each of your assets, as well as an overall risk management approach to your entire portfolio. You have the option to quantify your risk appetite in the hundreds, thousands, or tens of thousands of dollars. Regardless, you should refer to that as your overall risk limit for the entirety of your investment journey.
Risk Tolerance: A Quantifiable Limit for Accepting Risk
A popular metaphor for risk appetite versus risk tolerance is a highway speed limit and the speed at which a vehicle attracts the attention of the highway patrol. If you’re the driver, you don’t necessarily have to reach the max speed limit to be in danger of getting a ticket. That’s because, at a certain speed, the authorities will already have their eyes on you.
The same principle applies to risk tolerance. In a nutshell, risk tolerance is a way of quantifying the minimum and maximum variation levels of risk you’re willing to expose yourself to when trading in a particular asset. You can measure your risk tolerance in terms of a minimum and maximum percentage of your asset’s value, or you can measure it according to a minimum and maximum price variation. When the value of your asset nears that “risky” threshold, you may want to revisit your investment strategy and make the necessary adjustments. You’ll also want to do this before and not after the fact.
Striking the Perfect Balance Between Risk Tolerance and Risk Appetite
Now that you know how risk appetite differs from risk tolerance, it won’t be as hard for you to apply both of these concepts to your investment strategy. Below are a few tips for deciding on your benchmarks:
Acknowledge the Risks Involved with Your Particular Asset
Your risk appetite and risk tolerance are fundamentally related to the type of asset you’re trading in, as some assets are inherently riskier to invest in than others. It will be more realistic for you to have a greater risk appetite for speculative assets as opposed to conventional ones, given that the former are often associated with a higher risk of financial loss. But no matter how big or small your investment is, and no matter which asset class you’re investing in, never expose yourself to any risks that you aren’t ready to deal with.
Quantify Your Risk Appetite and Risk Tolerance
Once you’ve settled on the type of asset you want to invest in and once you’ve acknowledged the risks that come with it, it will be time for you to define two important things. These are your investment objective and your risk criteria. Make sure that your risk appetite aligns with your goal for the investment, and that your risk criteria are both realistic and actionable.
Monitor Your Investments and Be Aware of Your Risk Exposure
If you’ve determined the numbers that govern your risk appetite and risk tolerance, apply them to the assets in your portfolio. Check on your investments constantly and use tools like online price trackers to get daily updates on the market. Your risk exposure may vary from day to day, and there are certain periods in which you’ll be more vulnerable to risk than others. What matters is that you stay on top of your investment situation and that you know exactly when to respond to risk.
Conclusion: Developing the Right Risk Attitude for Your Investments
In the end, a greater understanding of concepts like risk appetite and risk tolerance will impart you with the right risk attitude. As you’ll discover along your investment journey, a balanced and clear-headed risk attitude is the hallmark of a successful trader. If you learn from the greats and do your research, you’ll master the risk-related aspects of investing in no time.