Assessment of risk tolerance is a crucial part of the asset allocation process and helps the investor in constructing optimal portfolios. Take the help of a financial planner to know how much risk you can handle
It is important to understand the concept of risk tolerance and assess the same. Every investor needs to understand how much risk he is willing to take and what type of risks he is more concerned about. Risk tolerance is a function of various factors such as age of the investor, investment goals, horizon of holding period,other financial commitments, etc. It is often misunderstood by the investors and there exist some difficulties in measuring the same. Let us discuss in detail risk tolerance and how to measure the same.
What is risk tolerance
From the investment science perspective, risk tolerance is nothing but the amount of risk that an investor is comfortably taking or the degree of uncertainty that an investor is able to handle.
In other words, it is the point at which you can no longer take a stock market downturn and move your money into cash. We all have a tipping point and it is important to find it. Often this term is confused with risk capacity. Risk capacity is the magnitude of risk that an investor should take to achieve the desired financial goals. It can be measured examining the holding period and income requirements. For instance, if you are a high net worth individual then you would have a high capacity for risk during a market downturn. You would have enough assets to live off on during this time period.
Measurement of risk tolerance
Measuring risk tolerance accurately is slightly tricky. There are two common methods to estimate an investor’s tolerance for risk. The first method is a clear understanding of the investor and his history with investment securities. The second method is to use a questionnaire designed to elicit feelings about risky assets and the comfort level of the investor given certain changes in the portfolio.
The various questions capture the investor’s attitudes, current behaviour, feelings, age, life stage, portfolio size, personal comfort level, income, financial goals, etc. Risk tolerance of an investor also changes over a period of time with changes in market shifts, life events, etc. Generally, risk tolerance can be assessed by a professional financial planner who could use any one of the above methods or combine more than one method.
Why risk tolerance is important
Assessment of risk tolerance is part and parcel of appropriate asset allocation and help in constructing optimal portfolios. Investing without considering risk tolerance is like sleepwalking to the edge of a cliff. Assume that you are investing in shares without thinking about how you will react if their value drops. A big danger then is freaking out and fleeing the market. Then you are falling into the common investing mistake of selling low. Another danger is playing it too safe if you do not take a reasonable amount of risk to reach goals. Taking a slightly more aggressive position to get better returns can make a huge difference over the long haul.
Investors in consultation with financial planners must assess their risk tolerance for the best asset allocation strategies. Assessing your risk tolerance may not guarantee you will sleep better but will provide you a basis of what you can withstand.
Appetite for risk
- Risk tolerance is the amount of risk that an investor is comfortably taking while risk capacity is the magnitude of risk that an investor should take to achieve the desired financial goals
- One way to estimate an investor’s risk tolerance is to have a clear understanding of the investor and his history with investment securities
- The second method is to use a questionnaire designed to elicit feelings about risky assets and the comfort level of the investor given certain changes in the portfolio
The author is a professor of finance & accounting, IIM Tiruchirappalli