When you hear the word ‘risk’, how do you feel? Do you see fear or opportunity? Do you imagine ‘apprehension’ or ‘thrill’? What about ‘investment risk’? Do you become worried that you will be left with no money? Or do you believe that risk is just an essential part of the investing process? Do you know what your risk tolerance is?
Ask yourself these questions to better understand your risk tolerance. You need to think about your behavioral tendencies. For instance, think about what actions you are likely to take after experiencing a significant investment loss or the decisions you made in the past when the markets went down.
Your risk tolerance lies somewhere between the answers to the above questions and your behavior towards your finances. Before we get into that, let’s understand risk tolerance.Learn how to mange your money & create wealth, Download your FREE eBook now
What is Risk Tolerance?
In simple words, risk tolerance is the level of risk you, as an investor, are willing to take. Note that being able to accurately gauge your risk profile can be tricky. Risk is not only about making gains or exploiting opportunities. It is also about tolerating the potential for losses and the ability to withstand market swings.
Behavioral scientists believe that ‘loss aversion’ or the fear of loss can play a bigger role in decision making than the anticipation of gains. Since risk tolerance is based on your comfort level with uncertainty, potential losses will help you gauge your risk profile.
How is it different from risk capacity?
Risk capacity and risk tolerance are not the same. Your risk capacity shows how much investment risk you can take on. Note that it is the ability and not willingness. Risk capacity is determined by the individual’s financial situation. Unlike risk tolerance, which may or may not change throughout your life, risk capacity will change depending on your personal and financial goals, and the time horizon needed to achieve those goals.
For instance, if you run your own business or if your kids are approaching college, you may be less likely to comfortably take on high risk investments.
However, if you are single and not having any major financial obligations, you might be willing to put your money in risky investments. Situations such as a job loss or an accident that leads to disability or even an inheritance can alter the amount of risk you can afford, that is, your risk capacity. So, risk tolerance is how much risk you are willing to take and risk capacity is how much you can afford.
How to gauge your risk tolerance?
You first need to understand how much risk you are willing to take and which types of risk worry you. Your risk tolerance is determined by a combination of factors. These include your investment goals, your investment experience, how much time you have to achieve your goals, your financial resources, and your ‘fear factor’. These factors will give you an idea about your risk profile. If you think all this is hard work, there is a simple chart that can help you find out which risk profile you have.
This chart is the risk pyramid. Have a look at the pyramid.
Source: The Tortoise Mindset
Investments at the top of the pyramid tend to be speculative. Some of them are illiquid too. This means that you won’t be able to quickly convert those investments into cash without loss of value. While they do offer the potential for higher returns, they also carry greater risks for loss of principal than investments at the bottom of the pyramid. Less risky investments at the bottom of the pyramid are more liquid and offer lower, stable rates of return.
From the pyramid, see which of the investments that you will prefer. Make a tick against each of the investments in the risk profiles that you are more likely to choose. Total the number of investments for each of those risk profiles. The risk profile in which you choose the most investments will be your risk profile.
Not convinced? If you have chosen an equal number of investments in all the profiles, then you have a high-risk profile. If you chose no investments in the high-risk profile and equal numbers in the moderate and low-risk profiles, then, you have a moderate risk profile. If you chose only investments from the low-risk profile, then you fall under the low-risk profile. Your preference for investments will determine your risk tolerance when you use the risk pyramid.
Risk tolerance by time horizon
There is a term called ‘age-based’ risk tolerance. It is conventional wisdom that a young investor has a long-term time horizon for financial goals and hence can take more risk. Following this logic, an older individual will usually have a short investment horizon, especially if that individual has retired and so will have a low-risk tolerance. While this may be true in general, there are certainly several other considerations that might come into play.
However, you need to be careful about blindly following conventional wisdom. For instance, don’t think that just because you are retired that you should shift to conservative investments, such as fixed deposits. While this may be appropriate for some of your money, it may not be appropriate for all because only equities can give you higher returns in the long run. With fixed-income investments, you might get lower returns which may not be enough to meet your day to day expenses. With today’s growing life expectancies and advancing medical science, the 65-year-old investor may have 20 years (or more) to live.
Risk tolerance limitations
Your net worth and the available capital will limit your risk tolerance. Net worth is just your assets minus your liabilities. Capital is money available with you to invest or trade. This should be money that will not affect your lifestyle if you have losses. An investor with a high net worth can assume more risk. If your net worth is much higher than the amount that you are using to invest, the more aggressive your risk tolerance can be.
Those with little to no net worth or with limited capital are often drawn to riskier investments like futures or options because of the lure of quick, easy, and large profits. They think they have higher risk tolerance. However, their risk capacity is low and they can’t make investments based on their risk tolerance. When too much risk is assumed with too little capital, you can be forced out of a position too early. On the other hand, if you are using limited or defined risk investments, it won’t take you long to recover from losses.
Knowing your risk tolerance goes far beyond being able to sleep at night or stressing over your investments. It is a complex process of analyzing your financial situation and balancing it against your goals, finances, and objectives. You can use tools such as mymoneysage.com to find out your risk profile. Just open a lifetime free account.