Too many of us keep too many restrictions on our Risk Tolerance leading to a concentrated exposure to less risky or risk-free investments. But Risk avoided in investments means Return avoidance as well and therefore puts our long term financial goals in jeopardy.
Ever thought about your Risk personality when it comes to investments? Are you too Risk averse and therefore have you set your limits for risk tolerance too low? Does it make you stay away from market investments or lead you to have a fragile risk composure, the inability to remain calm and rational when faced with unfavourable outcome? And how about its impact on the achievement of your financial objectives?
We will probably never ask such questions to ourselves because we’re better off avoiding the risk, it lets us remain at peace with our emotions. It is important, however, to understand one’s risk personality and alter the behaviour if its detrimental to financial well-being. An individual may require some astute risk taking to meet critical financial goals. These goals may include a planned house purchase, a big-ticket future expense like travel or education or marriage, or building nest egg for retirement, which is often ignored especially when you are young, all of which require a huge outlay and some advance planning.
The objective of this brief article is to examine investor’s risk perception in general and present a useful way to to think about Risk while striving to fulfil financial objectives.
Risk aversion is natural
Most individuals are naturally risk averse. Who would want to flirt with a possibility of ending up with a financial loss and given a choice, who wouldn’t want to avoid such an outcome? Risk aversion or disinclination towards risk is natural especially when it comes to finances. However, all it does is to lower the Risk Tolerance, which simply means a reduced willingness to engage in risky behaviour in which possible outcome could be negative. Consequently, a more risk-averse person would select investments that holds a greater percentage of risk-free assets which usually entails a compromise on yield and liquidity. This is a result of actively pushing away any thought of deploying savings in risk investments, like equity shares and mutual funds, or at best, building a smaller exposure to such assets which is only too small to have any meaningful impact.
Data source: Handbook of Statistics on the Indian Economy 2017-18, RBI
Counter-intuitively, Risk aversion may also cause investor to chase risk or become a risk-seeker in some cases. Retail investors have often been seen to chase momentum in equity markets based on their false impression of lower risks in rising market and the lure of making quick profits. However, when the market cycle turns, as eventually it does, the individual investors find themselves unable to counteract their emotions to losses and exit during bear markets suffering financial losses. Sadly, this sour experience, which could have easily been altered with some financial knowledge and experience, may cause the investor to turn only to safe investments in future.
How should you determine your ability to take risk?
The subjective interplay of risk attitudes thus first affects individual investor’s risk tolerance and eventually it influences their perceived Risk-taking ability or Risk capacity, which ought to have been an objective measure. Its important to understand Risk capacity which is the ability to bear financial loss without putting future financial commitments at any risk because this should ideally determine investor’s exposure to risk assets. However, measuring Risk capacity, as also Risk tolerance, is anything but simple. A few simple principles may be kept in mind which determine investor’s Risk capacity:
- If the amount set aside for investments is small part of investor’s total wealth, then the ability to take risk with these investments should be higher
- Similarly, a higher scope for future savings should mitigate the need to dip into investment portfolio
- A longer time horizon also increases ability to take risk because it allows sufficient time for recovery from any short-term fluctuations. For example, an investor who is closer to or into her retirement stage, is constrained in her risk-taking ability
- Additionally, flexibility in adjusting the financial goals, if any of them are desirable but not necessary should lend additional support to investment portfolio to withstand fluctuations. By the same token, an investor may be constrained if the size of her financial goals are large enough relative to total wealth
Profiting from risk – how to modify individual risk behaviour
While its important to be aware of both, Risk tolerance and Risk capacity, one must also balance them with Risk need which is the amount of risk an individual need to take in order to meet her financial goals. It is likely that, for many investors, the Risk need may be higher than their Risk capacity, which itself may have been squeezed by their heightened risk perception. How must an investor handle this self-defeating situation?
Financial literacy is the only answer. It is advised that investors must seek to understand the basic principles of markets and financial risk which will help improve their risk perception. Less financial knowledge will only make them overweight the risks in financial investments when historical reality over long run provides solid evidence to the contrary. Better understanding of financial risk will prepare the investor to anticipate the possible variation in performance over time, and recognize the benefit of taking more financial risk as a means of achieving long-term financial goals.
In conclusion, although staying within Risk tolerance zone is important for an investor to cope with market swings, keeping it too restrictive may prevent a good long-term financial outcome. Individuals must therefore look beyond mere psychological factors when accounting for risk in their investments. They can broaden their risk perception through financial knowledge and experience, which will help them fulfil their financial goals while better managing the associated risks.
Disclaimer: Investment risk management requires professional expertise. Readers are therefore suggested to consult registered financial advisors before making investment choices. The views in this blog post are personal.