What is your Risk quotient?, Understanding our risk capacity

Most of us wants certainty in life and risk is actually the uncertainty on the outcomes. Risk as defined by several people is “The chance that an investment's actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment.”  So are we risk averse or ready to take the risks? The answer to this question is often determined by our own personality. Some people, by nature, want to play safe; as they do not want to lose their sleep over the prospect of losing money. We can call them risk averse person. On the other hands there are people who are aggressive, they are motivated by prospect of making money rather than the risk of losing it. They are called the risk takers.

Out behaviour is driven by fear and greed and these two emotions determine our risk taking behaviour. Further Risk taking behaviour may not always remain same it can change over time. For example, in bear markets risk aversion is seen to increase whereas in bull markets risk taking increases. Risk appetite can also change with change in personal situations. Willingness to take risk is known as risk appetite. However, willingness to take risks may or may not be correlated with the person’s ability to take risks. For example, a 23 year old young professional with good income and no liabilities may have low risk appetite, even though his ability of taking risks should be high on the other side a person in his 50s is comfortable to take risk. The ability to take risks is known as the risk capacity of an individual.

There is very clear difference between risk appetite and risk capacity. Our investment decisions should ideally be guided by our risk capacity and not your risk appetite, however generally it is the other way around. Risk return relationship is one of the fundamental laws of finance. We cannot get higher returns unless we are ready to take more risks.

·       An investor with low risk appetite and high risk capacity needs to understand, that he or she may be compromising on their long term financial future;

·       An investor with high risk appetite and low risk capacity needs to understand the potential implications on financial safety.

In this post we will try to understand how investors can measure their risk capacities and put it to practical applications in their investment decisions.

1.   Rule of 100 for Asset Allocation

This is a very popular asset allocation formula for measuring risk tolerance. Simply put, we should subtract the investor’s age from 100, and the result suggests the maximum percentage amount of the investor’s portfolio that should be exposed to equities. So for a 30 year old investor, this rule suggests that 70% of his or her portfolio should be invested in equities, and for a 50 year old investor, this rule suggests that 50% of the portfolio should be invested in equities. However we should understand that, this formula, is a simple practical methods, not guaranteed to be perfect or optimal, but on an average, gives sufficiently good results. One criticism of this method is that, since average life spans are increasing, this rule may not give sufficient equity allocations to retirees and therefore may fall short of meeting the cash flow needs of the retirees through their lifetimes, especially in high interest regimes. Some financial planners believe that these days, Rule of 120 is more effective.

2.   Maximum Loss Rule

The Max Loss formula try to help investors determine the maximum percent of their portfolio that they should expose to equities. Max Loss depends on two factors:-

·        What is the maximum percentage of our portfolio that we can tolerate losing in one year?

·        What is the maximum percentage that we think the stock market can lose in one year?

The formula of Max Loss % is as follows:

Let us understand this with an example. Let us assume, you can afford to lose a maximum 10% of your portfolio value in a year and the maximum possible drop in the market in 1 year is 30%. In other words, if for some reason, a person had to redeem his portfolio what is the maximum loss he can afford to bear. The maximum market loss should be based on how much the market fell on an average in bear markets. A bear market is usually defined as the period, when the market fell by more than 20% from its high. Remember that, this is simply our expectation of maximum market fall percentage. One can never forecast how much the market will fall in a bear market. Let us further assume that we can get a risk free return of 7%.

In this case the Max Loss % will be (10% + 7%) / (30% + 7%). Accordingly Max Loss in % comes to 45.9%. Hence this should be equity allocation in our overall investment portfolio.

The maximum percentage of portfolio loss should not be an ad-hoc or whimsical number. We should factor in our monthly cash-flows, short term and long term liability situation and average liquidity positions to determine the maximum loss that we can tolerate on a particular situation.

3.   Time Horizon for Investment

Time horizon for investment is one of the most important factors in determining risk tolerance. The longer is the investor’s time horizon greater is his risk capacities. We should look at our investment goals and determine the time horizon for accomplishment of these goals. Longer the investment time horizon, higher is the risk capacity. This is because, volatility is a bigger risk in the short term than in the long term. Although there are no hard-and-fast rules, following are some general guidelines that can investors decide which investments types are suitable for various investment tenures.

         i.  Very Short term:

 Generally, term horizon of less than 2 year can be called as very short term horizon. Fixed income products are the most appropriate asset class in the short term. Short term can further be sub-divided in different investment tenures. Debt mutual funds i.e. Liquid/short term debt funds offer good solutions for variety of this investment needs.

       ii.  Short term:

 Short term horizon can be defined as 2 to 5 years. Fixed income along with some equity portion can be appropriate asset class in the short term. Balanced funds with conservative equity portfolio can be an ideal asset class in this investment part.

      iii.  Medium Term:

 Generally, medium term is 5 to 10 years. In this time horizon risk capacity is higher in medium term and therefore we can take little higher exposure to equities, to get higher portfolio returns and meet your investment goals. Hybrid investment with higher equity exposure can be ideal option in the medium term. Balanced mutual funds with aggressive equity portfolio can be excellent medium term investment choices.

      iv.  Long Term:

 Long term is a period which is more than 10 years. During this period our risk capacity is the highest. A long time horizon allows our investments to recover from temporary losses and create wealth for through the power of compounding. Equity is the best asset class for long investment tenures. Further within equity as an asset class, based on the risk appetite, we can take some exposure to small and midcap stocks (through small and midcap equity mutual funds) if our investment horizon is long term.

4.   Psychometric Risk Profiling

Many investment portals use psychometric risk questionnaires to profile an investor’s risk capacity. Investors are asked to answer a set of multiple questions and the answers to the questions help in evaluation of the investor’s risk tolerance. This can be done with the help of professional Advisers to get the right portfolio allocation based on individuals own profile and risk capacity.