Should you go online, you will not find a shortage of risk tolerance questionnaires. The questions can range from mundane to grim to entertaining, giving you options to select for each answer.
- How would your best friend describe you as a risk taker?
- You have just finished saving for the "once-in-a-lifetime" vacation. Three weeks before you plan to leave, you lose your job. You would…
- I understand the value of my portfolio will fluctuate over time. However, the maximum loss in any one-year period I am prepared to accept is…
- Over these two months in 2008, debt funds lost nearly 4%. If I owned a debt fund that lost almost 4% in 2 months, I would….
- My relative left me an inheritance of Rs 3 crore, stipulating in the will that I invest ALL the money in ONE of the following choices. The one I would select is….
What these questionnaires do is hope to give some sort of indication of an investor's ability to withstand short-term losses by asking the individual to imagine losses of certain magnitudes and see if that's something they have a comfort level with. Risk tolerance is nothing but your willingness and emotional ability to handle a certain level of loss in search of greater investment gain.
It is undoubtedly important. After all, it’s fairly self-defeating to construct a portfolio bulked up with stocks if you're likely to crawl under the covers the first time the market nosedives. Yet the fundamental issue with this approach is that it confuses someone’s capacity to take risk with their actual desire to do so. Consequently, risk capacity, which is a measure of how much risk your finances can realistically absorb, doesn’t get the attention it deserves.
Let’s look at a 26-year old professional who is living with her parents. She earns pretty decently, her expenses are fairly low, she has no dependents and is not in debt. Unfortunately, based on her family’s bad experience with equity, she is wary of that asset class. Consequently, her savings are channelized into bank fixed deposits, the Public Provident Fund, or PPF, and the Employees Provident Fund, or EPF.
This young lady has a low risk tolerance despite having a high risk capacity. Risk tolerance is her attitude towards taking risk. Risk capacity is her financial ability to actually do so. Risk capacity is all about the financial aspects of an individual’s ability to sustain a market decline without suffering an unacceptable loss of life style or quality of life. The latter will be based on the individual’s assets and liabilities, actual income and its various sources, time horizon for the various goals, and number of dependents.
The professional, despite having a high risk capacity, is letting her low risk tolerance--essentially, her comfort level with short-term volatility--dictate her long-term decision-making. If she begins to create an equity portfolio for her retirement, her investments in the stock market can go up and down and survive many cycles. It will not make much of a difference if she stays invested because she would need most of the money decades from now. In other words, she has a high risk capacity.
Too much focus on risk tolerance is that you're essentially letting your gut drive part of your decision making, which is not recommended. When investors place too much emphasis on risk tolerance and how they feel about losses, particularly short-term ones that they may be able to recover from, they run the risk of an overly conservative portfolio when saving for certain goals such as retirement.
Worth noting is that risk tolerance is not static. People overestimate their risk tolerance when the market is relatively good. And then they really pull in their horns when things go bad, and are inclined to dump everything and switch to a more conservative mix at what, in hindsight, could be an inopportune time.
This is where risk capacity really comes to bear. In a bad market, investors tend to let risk tolerance take the reins and cause them to sell when the market is maybe at a trough. This results in those paper losses turning into real losses.
Risk capacity is a much more important concept for people who are putting together their portfolios because it focuses on one’s actual ability to withstand losses in their portfolio. In reality, people behave differently from what they express in a logical questionnaire. When the stock market plunged in 2008 and 2011, investors realised that their risk tolerance was not as high as they perceived it to be. Years later when the market steadily climbed upwards, investors were once again willing to take risk. Bull markets make investors brave and results in them overestimating their risk tolerance.
On the flip side, you may have a high risk tolerance but not the capacity.
Risk capacity is also a function of the time horizon. If you have a very short-term horizon, your capacity for risk is obviously different than if you were talking decades though your tolerance may be high. Which means that if you have 5 years to retirement, you cannot withstand losses of 35% in a portfolio that is packed with stocks. You wouldn't be able to make that back before you need to start drawing upon your portfolio.
The final word: Risk tolerance and risk capacity are two very important concepts in the multifaceted topic of risk. Neither can be ignored. But it would be wise to let risk capacity lead the way.
To encapsulate, here are the three learnings for an investor:
- Risk tolerance and risk capacity mean two different things; don’t conflate the two terms.
- Neither term is static. As circumstances change, the risk capacity of an individual changes. Ditto with changing market scenarios. Investors tend to have a (perceived) higher risk tolerance in bull markets only to realise that they were mistaken when the plunge happens.
- Just because you can afford to take risk doesn’t mean you should. Conversely, just because you don’t want to take the risk (risk tolerance) does not mean you cannot afford to (risk capacity).
