Question

Why is risk tolerance important in considering portfolio design? How does it interface with desired returns of the investor as we construct an “efficient” portfolio?

Answer 1

Risk tolerance means the ability of the investor to take the adequate amount of risk, because the investor risk taking capabilities are different based upon the potential and capital requirement of different investors.

Risk loving investor would be more likely to take risk in order to maximize overall rate of return, and it is often said that the higher the risk, the higher will be the return.

Risk averse investor would be likely to take lesser risk and would be likely to gain a normal rate of return, as he would not be projecting to make a higher rate of return from his investment, because his risk will be too low and he is afraid of taking any unnecessary exposure.

An efficient portfolio is focused at maximization of the return by minimization of the risk and it can help both these types of investors by adequately allocating their risk tolerance to the proper assets. So and investor should be properly aware about his risk taking capability and loss tolerance in order to survive in the market.