Risk Tolerance
Risk Tolerance
Introduction
Your risk tolerance is important when it comes to investing. Because after all, you must decide on how much risk to take when it comes to your investments and what’s also challenging about your risk tolerance is that it means different things to different people. If I’m investing Rs.2000, risk to some people means I lost everything. To other people, risk might mean that my Rs.2000 is now worth Rs.1800, and yet, a third way people might view risk is that I was expecting Rs.2000 to grow to Rs.2,200 and it only grew to Rs.2,100. So risk tolerance really can mean a lot of things to different people. But we want you to focus on a few things as it relates to your risk tolerance.
How comfortable are you with investments?
First of all, if you don’t understand the investments that you are putting money into, that’s a formula for disaster. So it would be better to stay away from that. But as it relates to investing in stocks and bonds and other types of investments, what are you comfortable with and what aren’t you comfortable with? For most people, it can make sense to balance out their risk tolerance by investing in different types of investments. Some that are aggressive and growth oriented and some that are very conservative, as a way of balancing our risk. But it’s important and we would like to ask you, if you invested Rs.10,000 today, what would be too much risk for you? Where are you comfortable with it? The markets are going to go up, they are going to go down and a lot of that is out of your control. But you can make sure you are following an investment plan that makes sense for your situation as based on your risk tolerance. It’s kind of the sleep at night factor if you will. You know if you are the type of person and you have that personality where you do your investing, and it’s out of sight, out of mind, you are not thinking about it too much, then perhaps you can invest a little more aggressively. If you are up at night worried about investments and the stock markets stressing you out, and you are reading about it on the internet or in the newspaper, may be you are complaining to your spouse about it, that can be a sign that you are investing too aggressively for your personal tolerance for risk. And so the key factors when you are choosing investments are going to be always, how you feel personally about risk and what the rest of your situation looks like before choosing any investments or before investing your money.
Risk Tolerance Classification
Risk tolerance can be classified based on one’s investment objectives:-
Conservative: A conservative investor values protecting principal over seeking appreciation. This investor is comfortable accepting lower returns for a high degree of liquidity and/or stability. Typically, a conservative investor primarily seeks to minimize risk and loss of principal.
Moderate: A moderate investor values reducing risks and enhancing returns equally. This investor is willing to accept modest risks to seek higher long term returns. A moderate investor may endure a short term loss of principal and lower degree of liquidity in exchange for long term appreciation.
Aggressive: An aggressive investor values maximizing returns and is willing to accept substantial risk. This investor believes maximizing long term returns is more important than protecting principal. An aggressive investor may endure extensive volatility and significant losses. Liquidity is generally not a concern to an aggressive investor.
How to determine how much risk I am taking right now?
You might like sky diving, bungee jumping and so on but you must also be physically fit to participate in such activities. On similar lines, one may be a risk taker and probably would not hesitate to put his money in risky avenues. However, it is imperative to take into consideration the present situation before taking investment decisions.
The following factors will help to measure how much risk you are taking now.
Income: Your income is an important determinant to gauge your risk tolerance. If your income is high enough, you will not mind taking higher risks while taking investment decisions and vice-versa. This is because small setbacks in your portfolio will not affect your ability and capability to invest.
Expenses: Your outgoings also influence the risk which you can afford to take while investing. Thus although you may be having a high income, but your disposable income is petite you could be refrained from taking high risk. Hence it is imperative for you to streamline unnecessary expenses, so as to keep your financial health in pink
Financial Responsibilities: such as children’s education and marriage, and your current financial situation are vital in deciding your risk taking ability. Only if you have enough funds to meet your short term goals, can you expose your portfolio to high volatility.
Nearness to goal: The time left for the realisation of financial goals also determines your risk appetite. If you are adequately away (in terms of number of years) from meeting a financial goal, you can afford to expose your portfolio to higher risk which might enable you to create more ‘wealth’ in the long term. But if your financial goal is drawing nearer, it would be more prudent for you would be a risk-averse investor to preclude wealth erosion.
Sufficient Liquid Cash needs to be saved in your bank account to sustain your present lifestyle for the next 12-18 months in case you lose your job or for any other financial emergencies.
A suitable Life Insurance Cover is essential to provide financial security to your dependents in case of any untoward event. This will help your family in paying off your debts and also meeting household expenses. An inadequate life cover will definitely lower your risk tolerance as you would need to generate predictable flows on your investments to protect your savings from the risk of loss.
Health Insurance ensures that you get appropriate medical care when you need it. An accident or illness can cause a huge hole in your savings or even worse, create a huge liability, if you are not insured. If you are not covered by a good health insurance policy which can take care of your hospitalization and other expenses, you cannot afford to have a high risk tolerance.
Conclusion
To sum it up a high risk tolerance means an investor is aggressive and will find satisfaction in taking higher levels of risk in exchange for the possibility of higher rewards. It also means that the investor can tolerate larger losses, knowing that there might be larger gains later. A low risk tolerance means an investor is conservative and will take comfort in preserving principal, knowing that lower risk instruments will mean lower returns. Risk tolerance changes over time. Age, income and circumstances all interact to form your current level of risk tolerance. As various factors change in your life, you will find that your risk tolerance rises or falls. Pay attention to your current risk tolerance, and be aware of the way your feelings about risk are affecting your judgement. Investors can assess their degree or risk tolerance by taking one of a number of different risk tolerance questionnaires. In addition, it can be useful to review worst case returns for different asset classes historically in order to get an idea of how much money one would feel comfortable losing if his or her investments have a bad year or bad series of years.
Anup Nair
Dilzer Consultants Pvt Ltd
Reference:-
https://googleweblight.com/i?u=https://m.economictimes.com/wealth/plan/what-is-the-difference-between-risk-capacity-and-risk-tolerance/articleshow/56967886.cms&s=1&hl=en-IN
https://www.investopedia.com/articles/pf/07/risk_tolerance.asp
https://www.cnbc.com/2015/08/04/how-much-investment-risk-can-you-stomach.html