Do bumps in Sensex send you into sweats, or to the trading room floor? An understanding of your risk tolerance is an important step in managing a healthy portfolio. Most investor’s I’ve encountered concentrate solely on investment returns and ignore investment risk. Because the level of investment risk primarily determines investment returns, we need to apply a more rational approach to determining the appropriate level of investment risk in our investment portfolios.

What is risk?
For starters, the term ‘risk’ refers to the probability that an action or event will negatively or positively impact your ability to achieve your objectives. Most commonly, people use this term in the context of negative impacts, but remember the old mantra: with risk comes reward.
Why Risk Is Important?

In order to be successful with your long-term investment goals, you must understand the level of risk you best feel comfortable with. When you feel good about the level of risk in your investments, you have a better chance of being successful in your long-term financial goals.

When determining your investment portfolio it is important to balance your risk tolerance or willingness to take risk with your risk capacity or ability. As similar as these terms sound, they’re actually quite different. Risk tolerance is the amount of risk you WANT to take. Risk capacity, on the other hand is the amount of risk you NEED to or you CAN take.
Risk Tolerance/Willingness to Take Risk
Willingness to take risk is purely psychological. It involves your emotional reactions to portfolio losses and market downturns. Simply stated, risk tolerance reflects your attitude toward risk. Are you comfortable with investments that might produce dramatic swings in your portfolio value over time? If so, then you’re relatively risk tolerant. On the other hand, if these sorts of things would keep you up at night, then you’re relatively risk averse. Your previous investment experience and knowledge of investment history also influence your willingness to take investment risk.

Risk Capacity/Ability

Risk capacity is a measure of an investor’s financial ability to sustain risk. In a practical financial planning context, risk capacity is measured in terms of age (younger has more recovery time and longer investment horizon), wealth (relative to needs), earning power (if necessary, can continue to work longer), short-term need for funds. Rather than being an emotional construct, risk capacity is grounded in the reality of your situation. Ability is driven by your household budget. Your ability for risk is measured in the funds you have available to put at risk. Those are the funds (in lump sum or on a cash-flow basis) that are not required to meet your household budget needs (after establishing an emergency fund and paying down high interest consumer debt). In short, you can afford to lose the funds you’re able to put at risk in the short term. You do not require them to support your current lifestyle.

 Assessing- Risk to Be Taken

Risk tolerance is crucial because it can greatly influence your emotional reaction to your portfolio. Invest too far out of your comfort zone (your appropriate risk tolerance) and you risk buying or selling for the wrong reasons. You will react improperly to wild swings in the markets and you hurt your portfolio.
Risk tolerance is typically divided into classifications such as conservative, balanced, or aggressive. Each level helps to determine what percentage of equities to hold and essentially helps to balance out the risk.

Example - Why risk tolerance isn’t enough.

Rahul and Dinesh both work as store clerks. They earn the same wage and have the same limited career options for the future. They are both 38 years old, so they have identical long-term time horizons, too.

• Rahul has a love for betting. His long-term gambling addiction means that he is willing to accept terrible losses, even if they jeopardize his financial stability in the future.

• Dinesh, however, is very conservative. He squirrels away his meager earnings and hates spending a penny on anything he doesn’t need.

Despite having identical financial circumstances, they have dramatically different risk tolerances. A portfolio based solely on Rahul’s risk tolerance might advocate all sorts of risky ventures, even though he’s only a store clerk and can’t actually afford heavy losses. Meanwhile, a portfolio based on Dinesh’s risk aversion would likely only invest in the safest government securities. Although the capital would be preserved, he would earn nothing more than the risk-free rate, and his portfolio would barely keep up with inflation.

If they invested according to their risk tolerance, the net result would be less than satisfactory for both. In this case, a prudent investment strategy would have fallen somewhere between the two extremes.

Your risk tolerance is a measure of how much risk you can handle, but that is not necessarily the same as the appropriate amount of risk you should take. That brings us to the second risk assessment that should be done.

Financial risk capacity can be measured in many different ways, including time horizon, liquidity, wealth and income. People who have a high liquidity requirement - i.e. they could need access to their money at any time - are constrained to how much risk they can take. They are forced to avoid investments that might be potentially lucrative because they do not offer the required liquidity. Over the long term, volatility of the markets is dampened, and returns will move toward long-term historical averages. The longer the time horizon, the greater is the capacity for risk.
 
Example - Differences in capacity to tolerate risk.

Let’s consider the fate of three investors who each see a 50% drop in the value of their portfolios.

• Mr. Sahukar- Mr. Sahukar is over 80 years old and has made good money as a businessman. His portfolio investment is Rs.5 Cr.

• Mr. Rajiv Shah- Rajiv, 40, works as a head accountant in a firm. He has a family to support and is slowly nearing retirement. His retirement portfolio is of Rs 25, 00, 000.

• Dhruv- At age 25, is just beginning his career. He recently started investing & has a portfolio of Rs. 50, 000.

A loss of 50% would drop Mr. Sahukar down to a paltry Rs. 2.5 Cr. But he would not worry much about the loss; the amount is more than enough for him. Dhruv, too, has the capacity to absorb a financial hit of 50%. He has many years to continue saving and investing before he needs to think about retirement.

Rajiv, however, does not have the financial capacity to tolerate risk, even though he might be more than willing to gamble it all away on some risky investment. He has a family to support and less than two decades left until retirement. A 50% drop in the value of his portfolio would be devastating!

Those with high income and high wealth can make higher risk investments because they have funds coming in regardless of the market conditions. Similarly young investors, with limited funds to invest, have the capacity for high risk because they have longer time horizons. Any short term drops can be waited out, lowering the chance of having to withdraw before the markets bounce back.

The combination of an investor’s financial risk capacity and emotional risk tolerance forms an overall profile that can be used to determine appropriate investment solutions.
“No reward will ever be large enough if the consequences of losing are too much to bear.”

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This entry was posted on Wednesday, June 24th, 2009 at 2:27 am and is filed under Financial planning, Mukesh Dedhia's published articles. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.