Difference between Risk Appetite, Risk Tolerance, and Risk Threshold

Risk guides your investment decision in terms of determining the kind of investments you make, the kind of stocks that make up your investment portfolio, and whether or not you attain your investment or financial goals in the long run.

Risk is undoubtedly an important factor in your investment. It guides your investment decision in terms of determining the kind of investments you make, the kind of stocks that make up your investment portfolio, and whether or not you attain your investment or financial goals in the long run.

It can also be the determinant of whether you invest and hold or whether you panic and sell your stock at the slightest loss incurred. While the terms risk appetite, risk tolerance, and risk threshold are generally used interchangeably – and for good reason, because they have the same objective of helping the investor find the risk position he or she is comfortable in, they have slightly different meanings.

Here’s the difference between all three of them:

Risk Appetite

When you think of appetite, you think of hunger or desire. How much risk do you have an appetite for? Risk appetite represents the degree of uncertainty the investor is ready to take in anticipation of a pre-determined level of profit.

In other words, if you want to be the next Mark Zuckerberg and you don’t mind whatever it takes to get there, then your risk appetite is high. If you will rather invest in highly speculate investments, then your risk appetite is also high.

Your risk appetite is usually tied to your investment objectives. If capital preservation is your goal, then your risk appetite will be low.

Risk Tolerance

The term “tolerance” is defined as “the ability or willingness to tolerate the existence of opinions or behaviour that one dislikes or disagrees with.” What this means is that while you might not be comfortable with a thing, you endure it up to a certain extent.

What risk tolerance, thus, provides is a range. It implies the ability of an investor to stomach a few additional losses that are beyond his or her personal preference. It shows how much risk the investor is willing to accept to attain his or her objectives.

Risk Threshold

While risk tolerance provides a range, your risk threshold provides a cap or ceiling. It represents the level of exposure the investor can take to a certain maximum.

The risks can be lower, but anything above the maximum is unaccepted. One of the ways investors do this is to put in a stop-loss order so that when things start getting out of hand, they know they can’t go any further.

Regardless of the term you’re using, the goal is to build an investment portfolio with a risk level you can live with. It could be the only difference between whether you’re fine in the event of a loss or whether you cannot sleep at night.

Written by Lawretta Egba.