Risk Tolerance is Personal

One of the basic rules or ratios of investing is that riskand reward are directly proportional – higher the risk, higher the returns andvice versa. However, every investor has a different capacity of the risk or thevolatility that comes with it, which they can stomach. The amount of your risk appetite determines the kind of asset allocation ideal for you and finally the path to reaching your financial goals. But, how do you determine your risk appetite?

The main reason why the thought of risk appetite struck me is the fact that in my role as an investment counselor I have come across various people from all walks of life. However, they all seem to display very different tendencies to risk. It made me think and realize that probably the rules of thumb I have read or known till now are not the best indicators for determining risk appetite.

Some rules of thumb that don’t work for risk

100-age

This was one of the earlier maxims I had read which essentially propagates the idea that you should invest in equities to the tune of subtracting your age from 100. So, if you are 30 years old, you should look to allocate 100-30 or 70% of your portfolio to equities.

However, in my experience, that’s not particularly true. It depends more on the individual’s comfort level with equities. I have now met people in their 90s who are happy to be even 50% into equities while with some middle-aged folks, I am still struggling to get them to divert some of their money from Term Deposits to Equities.

More the disposable income, higher the risk taking ability

In my previous marketing role, I had met a lot of consumers as part of forming insight. There was one respondent who is lodged quite firmly in my memory. He was around 25 years of age, working in a small company and earning maybe Rs. 30000-40000 per month. However, he was one of the most financially savvy persons of his age that I had met in a long time – used mobile & internet banking, made the most of credit cards and knew the best places to hunt for deals.

He was eating a sandwich when we asked him about his investing habits. He told us in a matter of fact manner that he invested indirect equities and had booked a profit of Rs. 8000 in a short span in a recent IPO. Having heard concerns of fear of losing limited money in the market, from his peers, we asked him whether he feared the risk that he was putting his money through. Through mouthfuls of sandwich, he responded – “Madam, even Spiderman needs to take risk”.

Contrast this to a Chartered Accountant I met recently who runs his own firm and has a big fancy office in South Mumbai. Clearly, his disposable income is far higher than the kid I described above. However, when I met him, he seemed to have shuttered down in his head to all talk of equity investing. He was happier investing in real estate (even if he sometimes had a bad experience as he had something tangible to show for it) or keeping his money indifferently timed Fixed Deposits.

More the knowledge, more the risk appetite 

Another rules of thumb often touted is the fact that the more you know about how economies work, more you will probably be willing to take risks. However, that is clearly not the case.

I recently met an official who works in RBI at his office. Yeah, my new role led me to the RBI office! The person we met was again in his 40s or 50s and happier keeping all his money in term deposits where his returns were “guaranteed under a contractual obligation”.

They say doctors make for the worst patients. Looks like economists follow suit in their own field.

Possible determinants of risk appetite

If these rules of thumb indeed do not apply to all investors, what can really be the determinants of risk appetite? There are some which come to my mind.

Time spent in the market

My boss has been in this field of investment counseling for more than a decade and a half now. He has seen the brutal bloodbath of 2008. Two of his favorite questions to ask a client to check for their investor maturity levels is: a. Were you invested in the market during 2008? b. If you were, did you stay invested or did you withdraw all your money?

The more time you spend in the market and show patience, the higher likelihood of an increased risk appetite. So, if you don’t already, start today with the less risky equity instrument like a Mutual Fund.

Past experiences

There are also clients who have made one bad call, never to return again. They are either victims of mis-selling or those who realised much too late that their risk tolerance for investments is lesser than what the product probably will lead to.

Some people have also grown up in families where some investment has gone wrong, which has led to the person completely turning off or turning in favour of a particular asset class.

Risk Capital

My father always told me “Invest in direct stocks only the money you can afford to lose completely”. This amount of money is referred to as Risk Capital. The proportion of risk capital varies for different people even in the same walks of life.

However, the thought of starting out on investing with some funds into a relatively safe vehicle like a mutual fund and assuming it to be risk capital can help make a start. Once you start, your experience in the markets only expands the risk tolerance levels.

Have you ever given your risk tolerance a real thought? What factors have influenced your risk tolerance? Let me know in the comments below.

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