“No risk, no return” is a saying that we’ve all heard. But what exactly is risk? And how much risk are you comfortable taking? These are questions that all investors, whether large or small, sophisticated or novice, must consider when determining their investment goals and objectives.
Risk is generally seen as the chance of something negative occurring. From an investment point of view, in its simplest form, it’s the possibility that you will lose part or all of your investment. Like most things in life, investing involves a trade-off between taking risks and earning returns. It is said that the riskier an investment, the greater the potential return. In other words, you are usually rewarded for taking risks but must also be willing to assume the likelihood of loss associated with more unpredictable investments. So why doesn’t everyone take high risks to get higher returns? I mean who doesn’t want high returns?
The reason is that some persons are simply not willing or able to take on high risks but are perfectly satisfied receiving smaller returns on investments that carry lower levels of risk. This brings us to the concept of risk tolerance. Risk tolerance essentially refers to your attitude towards risk and can be broken down into components: the ability to take risks and the willingness to take risks.
Let’s start with the ability to take risks. This is determined by objective data such as your financial situation and circumstantial restrictions. Generally, you have a greater ability to take risks if you:
- Are young and have a long timehorizon to recover from potential losses
- Have more human capital i.e., future earning potential
- Have a large asset base relative to liquidity needs
- Have stable income
- Have no dependents
- Are debt free
While the ability to accept risk is usually measured on a quantitative basis, your willingness to assume risk is based on a more subjective assessment of your mental attitude towards investing.You generally will have a lower willingness to take risks if you:
- Had a bad experience with investing, i.e., suffered heavy investment losses
- Are explicit about wanting to avoid losses or maintain the real value of the portfolio
There are times when an investor’s ability to take risks conflicts with his/her willingness to take risks. For example, a young, wealthy, single investor may not be willing to take aggressive risks even though he/she can. Conversely, a situation can arise when a retiree with several dependents and a lot of debt may be a risk seeker. In such cases when there is a conflict between an investor’s ability to take risk and their willingness to take risk, a good investment adviser or prudent investor should always err on the side of caution and adhere to the following rules:
- IF ability exceeds willingness -> honour willingness
- IF willingness exceeds ability -> honour ability
Now that we have a good understanding of what risk tolerance is, we can move on to the classification of risk tolerance levels. Risk tolerance levels can generally be classified into 3 categories after your ability and willingness to take risks are assessed. These include:
- Conservative Risk Tolerance – Investors with a conservative risk tolerance are not willing to accept periods of extreme market volatility and only seek returns that match or slightly outpace inflation. These investors are primarily concerned with protecting their capital and will “lose sleep” whenever investments decline in value.
- Moderate Risk Tolerance – Investors with a moderate risk tolerance are willing to accept periods of mild market volatility in exchange for the possibility of receiving returns that outpace inflation. These investors are not bothered by small declines but do worry about large ones.
- Aggressive Risk Tolerance – Investors with an aggressive risk tolerance are willing to accept periods of extreme market volatility and wild fluctuations in prices in exchange for the possibility of receiving higher relative returns in the long run.
An investor’s risk tolerance level is NOT static throughout his or her life. WHY?
- Investment goals can change
- Financial situation can change
- Life experiences can change
It is therefore important to review your investment goals and objectives periodically especially as it relates to your risk tolerance to ensure your investment portfolio is appropriate for your needs.