Failing to accurately assess your personal levels of risk tolerance and risk capacity before throwing yourself into the investment ring can have a significant impact on your investment decisions and subsequent outcomes, yet not many people consider these until it’s too late.
In this blog you will learn:
- What the biggest risk in life is
- Why risk is important
- The 5 factors that impact risk tolerance and the three investor risk categories
- What is risk capacity
- Other risk considerations when it comes to your risk assessment
- The only 2 certainties in life.
Risk and its relationship with life – why is risk important?
Life is a series of calculated risks.
Nearly every decision we make is a delicate balancing act between risk and reward.
If you stop to think about it, every decision you make carries a margin of risk. No outcome can ever be 100 percent certain and, therefore, any decision has a chance of complete failure. We take risks, every day of our lives without knowing it.
There is always a chance that we’ll never make it to our desired destination, a chance we won’t get to see our loved ones again, a chance that tomorrow will never come. Life is all about risks – you take some, you avoid some, and others you put steps in place to reduce their impact.
Yet, according to Mark Zuckerberg, the biggest risk is not taking any.
Do you already have clear and concise SMART(ER) goals? These are key when it comes to making sensible investment decisions. Click here if you need to learn more about these.
As we have recently learned in a recent blog, available here, the most important investment decision in life is asset allocation.
Essentially, asset allocation is the way you allocate your time and money in such a way that brings you the maximum reward with the minimum amount of risk. It also assures that you reduce risk through diversification, protecting your investment portfolio from sudden changes in the market.
In the previous blog about asset allocation, I discussed the concept of investing under three different buckets, your
- Safe & Secure Bucket,
- Growth Bucket,
- Dream Bucket.
But how do you decide what percentage of the money you have to invest goes into your Safe & Secure bucket, what percentage goes into your Growth bucket, and what do you allocate to your Dream bucket?
We need to consider several elements of risk to answer this question.
Risk & Return
Risk and return are two key factors to consider when investing. All investors want to make the highest possible return from their investments; however, a potential return must always be balanced against potential risk. Indeed, the greater the expected return, often the greater the level of risk involved for a potential loss.
Before you consider getting involved in investing, you must create an accurate risk assessment, or risk profile for yourself. This risk assessment allows you to determine the most suitable investments to consider, taking into consideration your objective capacity (risk capacity) as well as subjective willingness to take on risk (risk tolerance) and the time you have to meet your goals (risk requirement).
Risk tolerance refers to the amount of loss an investor is prepared to take on when making an investment decision.
Knowing their risk tolerance level helps investors plan their entire portfolio and will drive how they invest. For example, if an individual’s risk tolerance is low, investments will be made conservatively and will include more low-risk investments and less high-risk investments. The following 5 factors influence Risk Tolerance:
Each investor will adopt a different time frame based on their investment plans. Generally, more risk can be taken if there is more time. An individual who needs a certain sum of money at the end of fifteen years can take more risk than an individual who needs the same amount by the end of five years. The more time you have, the more time you have to recover from any loss.
Financial goals differ from individual to individual. To accumulate the highest amount of money possible is not the sole purpose of financial planning for many. The amount required to achieve certain goals is calculated, and an investment strategy to deliver an outcome. Each individual will take on a different risk tolerance based on goals.
Usually, young individuals should be able to take on greater risks than older individuals. Young individuals have the capability to earn more over time and have more time on their hands to handle market fluctuations.
- Portfolio size
The larger the portfolio, the more tolerant to risk. For example, an investor with a $50 million portfolio will be able to take on more risk than an investor with a $5 million portfolio. If value of an individual share, for example, drops, the percentage loss is much less in a larger portfolio when compared to a smaller portfolio.
- Investor comfort level
Each investor handles risk differently. Some investors are naturally more comfortable with taking risks than others. Risk tolerance is, therefore, directly related to how comfortable an investor is with taking risks.
Investors are usually classified into three main categories based on how much risk they can tolerate.
The three categories are:
Aggressive risk investors have a good knowledge and understanding of the market and market fluctuations. Such types of investors are used to seeing large upward and downward movements in their portfolio and are more willing to take on greater risks.
They reap superior returns when the market is doing well and naturally face huge losses when the market performs poorly. However, they do not panic sell at times of crisis in the market as they are used to fluctuations on a daily basis.
Moderate risk investors are relatively less risk-tolerant when compared to aggressive risk investors. They take on some risk and usually set a percentage of losses they can handle. They balance their investments between risky and safe asset classes. With the moderate approach, they earn less than aggressive investors when the market does well but do not suffer huge losses when the market falls.
Conservative investors take the least risk in the market. They do not indulge in risky investments at all and go for the options they feel are safest. They prioritise avoiding losses above making gains.
The risk from ignoring your Risk Tolerance
Investing without considering risk tolerance can prove fatal. An investor must know how to react during periods of market fluctuation to maximise their returns. When the market drops many investors flee the market and sell low in the process, making a loss. At the same time, a market decline can be a great opportunity to buy. Therefore, ascertaining risk tolerance helps you make informed decisions in advance, avoiding making reactive hasty, ill-informed decisions potentially resulting in significant losses.
Risk capacity, unlike tolerance, is the amount of the maximum level of risk that an individual can afford to take based on his or her financial circumstances. It is quantification of your total ability to absorb (or handle) a loss, whether the loss is small, moderate, or large.
In general, the longer you can wait before needing your invested assets, the riskier your portfolio should be. This is because higher risk investments are compensated with a higher expected return, on average – and over longer time horizons, rough periods are often smoothed out. Also, you can keep adding to your investments as markets dip which means when the market begins rising again you have accumulated assets at better prices.
The rate of return necessary to reach your goals can be estimated by examining time frames and income requirements. This information can be used to help you decide upon the types of investments to engage in and the level of risk to take on.
An additional element of your risk assessment is your risk requirement. Say you have calculated you need a further $2 m in savings and investments in order to retire comfortably. If you are only 35 years old and still have 30 years of earning potential ahead of you, your necessary risk requirement to achieve an extra $2 M in savings and investments will be a lot lower than someone else who is already 50 years old and has only 15 years more opportunity to meet their investment goals. This risk requirement will impact on both your risk tolerance and risk capacity if you are to achieve your goals on time.
Balance of Risk
The problem many investors face is that their risk tolerance and risk capacity are not the same. When the amount of necessary risk exceeds the level the investor is comfortable taking, a shortfall most often will occur in terms of reaching future goals. On the other hand, when risk tolerance is higher than necessary, undue risk may be taken by the individual. Investors such as these sometimes are referred to as risk lovers.
Taking the time to understand your personal risk situation may require self-discovery on your part, along with some financial planning. While attaining your personal and financial goals is possible, reason and judgement can be clouded when personal feelings are left unchecked. Therefore, working with a professional may be helpful.
Once you do understand your personal risk situation, and the likelihood you will react negatively to market fluctuations, you are in a position to calculate your asset allocation under the Safe & Secure, Growth and Dream Buckets.
The only 2 Certainties in Life.
If Benjamin Franklin is correct, then everything other than death and taxes carries an element of risk.
Other blogs you might be interested in:
- What’s a financial plan, and why do you need one?
- How to reach your goals faster.
What’s your investor risk category?
Note: The information in this article is general in nature as it has been prepared without taking account of your objectives, financial situation or needs.