1. Investing: Risks and rewards

Investing: Risks and rewards

Often you have heard the statement that 'no pain, no gain'. In the investment science literature, the comparable phrase would be 'no risk, no reward'.

By: | Published: February 16, 2016 12:10 AM

Often you have heard the statement that ‘no pain, no gain’. In the investment science literature, the comparable phrase would be ‘no risk, no reward’. Accordingly, the investor’s objectives should be crystal clear in terms of both risk and returns. How you feel about risking your money will drive many of your investment decisions. Generally, investors’ risk-tolerance scale extends from very conservative meaning which you do not want to risk losing a single rupee irrespective of how little your money earns to very aggressive that is if you are willing to risk much of your money for the possibility that it will grow tremendously. In reality, most investors’ tolerance for risk falls somewhere in between.

Risk tolerance

Risk tolerance is more than a function of an individual’s psychological makeup, it is affected by various factors.

Stage of life

The needs and demands on your income differ depending on whether you are just starting your career, raising a growing family, putting children through college, or getting ready for retirement.

Income level

Generally people with lots of discretionary income can afford to take greater risks with their money than people who are just getting by or who depend on their investments for their income.

Assets composition

The majority of the assets that you have currently, are more risky then you can probably afford to take less risky investments as you already have risky assets. Contrary to the above, if you have adequate insurance coverage, cash reserves, etc. probably one can think of investing in risky assets.

To understand your risk tolerance, one needs to answer honestly the following questions: How much risk are you able to handle? How much risk are you willing to handle?

Ability to tolerate risk

Your ability to tolerate risk is nothing but your ability to handle an investment loss. If your investments carry enough risk that the loss would force you to reduce your standard of living you may be taking on too much risk. Building a retirement portfolio tailored to your risk tolerance is important. Apart from giving you peace of mind, it enables you to avoid making rash, emotional investment decisions during volatile market conditions.

Investors who risks more than they can genuinely tolerate often end up abandoning their investments at the worst possible time, incurring losses that they could otherwise have avoided by investing within their risk comfort zone.

Willingness to tolerate risk

Your willingness to tolerate risk also known as your psychological risk tolerance documents about the emotional side of investing. If the level of investment risk in your portfolio causes you stress, you may have accepted more risk than you are willing to tolerate. To lessen your stress, you might consider making your portfolio less risky. It is easy to overestimate your willingness to tolerate risk.

Literature shows that investors’ behaviour is more influenced by past investment experience and beliefs about the future. Think about the last time you dealt with an investment loss – how did you react? If you had trouble accepting the loss, consider reducing the risk of your portfolio. Set your portfolio’s risk at the lower of your ability and willingness to tolerate risk. You should consider both elements of risk tolerance before you make an investing decision.

Revise your asset allocation

Once when you understand your risk tolerance, you can construct your asset allocation. Assuming that you are approaching towards retirement, you adjust your asset allocation to help protect you from market risks at the same time retaining potential for upside movement.

This strategy will generate income from your investment while growing your overall portfolio. It is worth noting that risk tolerance will evolve over a period of time. This assessment need to be conducted periodically in order to ensure that your asset allocation reflects both your emotional as well as financial ability to tolerate risk.

To conclude, risk return relationship is one the essential principles of investment science. Hence, it is very important that investors do an objective evaluation of their risk tolerance before making investment decisions, instead of relying on perceptions. Investors can use the methods described above to determine the risk tolerance of the investor.

Risk tolerance

Risk tolerance is more than a function of an individual’s psychological makeup, it is affected by various factors.

The needs and demands on your income differ depending on whether you are just starting your career, raising a growing family, putting children through college, or getting ready for retirement.

Generally, people with lots of discretionary income can afford to take greater risks than those who depend on their investments for their income.

Your willingness to tolerate risk also known as your psychological risk tolerance documents about the emotional side of investing.

The author is associate professor of finance and accounting, IIM Shillong

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