Risk Tolerance: The 3rd dimension to investments
Jaidev was very clear about what he wanted to do with his money. He had sorted out the amount that he wanted to invest, his expectations in terms of returns and the time duration for his investments. So much so, that he had done his homework on his risk bearing capacity and to what extent he could afford to lose on his investments without the losses having any effect on his lifestyle or financial goals.
He was 32 years old, had Rs. 50 lacs to invest, wanted a double-digit return YoY, had a time horizon of 8-10 years and had a risk bearing capacity of 30% (of the sum invested). All his financial advisor had to do was plan out his portfolio, keeping these elements in mind. An aggressive portfolio was worked out considering Jaidev’s age, risk-taking capability and return expectation.
Unfortunately, the stock market tanked and in just about a year’s time, the portfolio valuation declined by Rs. 10 Lacs. The advisor reviewed the portfolio and gauged that the prices would soon recover and soar, as desired. Since the risk bearing threshold of the client was well within limits (20%), there was no reason to panic.
But that’s exactly what happened! The client started panicking, saying that he could not bear any further losses and wanted to make an exit. The advisor reasoned with him, explaining that it was a temporary phase and that the threshold risk limits were still far from being crossed. But to no avail.
So, what actually went wrong? Why did the client panic despite his high risk-taking capability?
Now, this is where the third dimension of investing – Risk Tolerance– comes into play. Risk tolerance is the ‘emotional capacity’ of a person to withstand losses without losing his nerve. Though the risk capacity was accounted for while designing the portfolio, the client’s risk tolerance levels did not match up. It’s similar to a billionaire who can afford monetary losses to the tune of lakhs while gambling but does not have the heart to actually lose money.
Does this incident have an important message? Yes, there are few very important takeaways that every investor should bear in mind. The following points will help you to ensure that your investment portfolio is designed to suit you better:
- Know your risk tolerance in addition to your risk bearing capacity
Always remember the difference between the terms – ‘risk capacity’ and ‘risk tolerance/appetite’. The former is your ability to bear a certain amount of financial losses without disrupting your lifetime spending needs and financial objectives while the latter is your emotional capacity to bear losses without panicking. They have to always remain in sync and be considered with a holistic perspective.
- Risk tolerance is not static
Risk tolerance is dynamic in nature and keeps changing with your situation. Review your portfolio every year to sync the same with your risk taking capability and ability.
- Inform your advisor about both
Always tell your financial advisor about both these elements – your risk bearing capacity and risk appetite. This will help them to look at your risk profile with a 360-degree view and they will be better equipped to ascertain the right portfolio mix for you.
Ventura Investment Advisory desk has successfully conducted accurate risk profiling for many clients and helped them invest suitably as per their financial goals. With the knowledge and technical expertise we possess, we can help you ride out the rough spots and achieve your portfolio objectives without missing a heartbeat. Happy Investing!
“Risk comes from not knowing what you are doing” – Warren Buffet
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