In investment science, very often people use the term ‘risk tolerance’. But, this term is alien to many investors as it is being used in portfolio construction to decide between investment in different asset classes and the like. Let us make an attempt to understand what is risk tolerance and how you should use the same in your wealth building mission.
What is risk tolerance?
Risk tolerance is the magnitude of the variability or volatility in the investment returns that one can bear or withstand. It is an essential concept in investing and every investor should assess his/her realistic risk tolerance level. If you do not assess your risk tolerance level correctly, in a volatile market you will panic and sell your holding at the wrong time and vice-versa. Proper understanding and assessment of risk tolerance helps the investor to trade-off the investment returns for a better ride over a period of time.
Assessing risk tolerance
In Western countries, researchers have developed specific questionnaires which will ask several questions regarding market scenarios and gauge the risk tolerance level. For instance, questions such as what would be the reaction of the investor if the market fell by 15% during the last one year. The answer options could be (i) Do Nothing (ii) Sell the shares immediately (iii) Buy more shares (iv) Wait for a couple of months to take a decision. The answer for the questions like the above, brings out the risk bearing capacity of the investors.
For instance, a young, well-educated person who is at the beginning of his career with no loans attached is expected to work for the next 35-40 years. This person probably has a comfort level of investing and losing Rs 1,00,000 in a higher-risk portfolio. Contrary to the above, a retired person who has a limited budget for his monthly expenses may not be able to afford to book a loss of the same amount owing to his age, education, employment, etc.
Technically, through these questions one can elicit (a) How much risk are you able to handle, and (b) How much risk are you willing to handle? Once your risk tolerance is assessed, it is easier to build a portfolio of assets that make you comfortable during a longer period and even during volatile times in the market.
While assessing your risk tolerance, be realistic and honest. The questionnaire helps to understand your risk tolerance and any over-estimation or under-estimation will not be helpful. Often, many investors think that they are aggressive investors but in reality, they behave like a moderate investor. So, in this process they end up selling some shares in their portfolio when the market falls.
One easy way to understand your risk tolerance is that if the level of investment risk in your portfolio causes you more stress, then you may have accepted more risk than what you are willing to tolerate. To reduce your stress, you should consider making your portfolio less risky. Investors should be realistic with his/her preferences which will help to decide the right investment choices upfront, instead of correcting it later.
To conclude, abandoning a well-thought out investment strategy suddenly owing to an unfavorable stock market condition will never help an investor to achieve his or her goals in the long term. Proper risk tolerance will help you to anticipate and prevent poor investing behaviour by choosing the right investment mix.
The writer is professor of finance and accounting, IIM Tiruchirappalli