When you get down to financial planning for your future financial goals, one term that comes up quite often is Risk Tolerance. What do we understand by investment risk tolerance? How to calculate risk tolerance in investing and is there is a proper method to measure risk tolerance? What are the types of risk tolerance and how is the concept of investment risk tolerance applied to your financial planning? But first what do we understand by the concept of risk tolerance?
What do we understand by risk tolerance?
We all know that there is a direct relationship between risk and return. For example higher risk is required to earn higher level of returns. That is why more risky assets like equities and equity mutual funds give higher returns compared to debt or money market funds. That brings us to the fundamental question; how much risk can you afford to take? That is what risk tolerance is all about. It is the amount of risk that you are willing and capable of taking on. There are various facets to risk tolerance. Typically, an aggressive investor will have a higher risk tolerance whereas a conservative investor will have lower risk tolerance.
What determines your risk tolerance? One factor is age. The younger you are the greater is your risk tolerance. This risk tolerance gradually reduces as you age. Secondly, how indebted you are? If you are heavily in debt then your risk tolerance will be low compared to another person who has low levels of debt. Thirdly, risk tolerance is also about your psychological make-up. Some investors are by nature more aggressive and therefore they have a higher risk tolerance. At the end of the day, risk tolerance is measured by your ability and your willingness to take on risk in search of higher returns.
What determines your investment risk tolerance?
There are broadly 4 factors that determine your risk tolerance and you need to run these four tests to determine your risk tolerance. Let us look at each of these tests in detail..
Test 1: What is your time horizon for investment?
This is a very important test. When you create your financial plan, different goals have different time frames. For example, you may want to buy a car in 2 years and book an apartment in 4 years. These are short term goals and since the time horizon is limited your risk tolerance will be low. Hence for such goals your investment mix must be biased more in favour of debt or money market mutual funds where there is stability and regular income. As you age, your time horizon for investments reduces and hence your risk tolerance also reduces gradually. That is why it is essential to progressively keep shifting your portfolio from equity towards debt to remove the cyclical risk in your portfolio.
Test 2: Do you have the stomach for taking on risk?
This is largely a psychological factor. If you invest in equities you need to be patient for a period of 5-7 years to actually earn solid returns. If you are likely to panic after a 10% correction in stock prices then equities are not for you. If you are looking to invest in equities then you must have the stomach to buy in the midst of fear and sell in the midst of greed. Most investors do exactly the opposite. Having a risk appetite is very important and your risk tolerance is largely determined by your stomach for risks. Especially, if you want to get into higher risk assets like sector funds and thematic funds then you really need the staying power.
Test 3: How exactly is your debt position?
You may wonder why your debt position is material to your risk tolerance; but it makes a huge difference. If you are heavily in debt, with most of it concentrated at the short end like credit cards and personal loans, then you have limited risk tolerance. These are committed payouts that you need to make and you cannot default on these payments. You cannot afford to take on too much risk of equities where these assets may stay below your purchasing price for too long. If you do not have the debt comfort then you may end up selling your shares in distress and worsening your financial situation. The total debt as a percentage of your assets and the cost of your debt is a big determinant of your risk tolerance.
Test 4: Do you have alternate income streams?
There are various ways in which you can get alternative income streams. Your spouse may be a working professional and that may be adding to your security and risk tolerance. You may have inherited assets which are giving you annuity income and that could also be increasing your risk tolerance. Lastly, you may have started investing very early and you may now be reaping the benefits of your corpus created. That will also substantially increase your risk tolerance levels. On the other hand if you are the sole breadwinner with no other streams to fall back upon, then you need to worry about your regular expenses, job uncertainty, business cycles, debt repayment, asset creation, future planning etc. Obviously, your risk tolerance will be relatively much lower.
Risk tolerance is the building block of your financial plan. Once you have bracketed yourself based on your risk tolerance that is where your actual job of planning your financial future begins.
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