Focus on risk tolerance key for good financial planning

It's usually assumed that younger investors have a high-risk tolerance as they have a longer time horizon to access their funds. But it doesn’t mean that all investment needs are same and so the attitude to them same

Investing requires multiple decisions from asset allocation to security selection to timing for the goals. What’s however most important is the identifying of the risk i.e., not just associated with the asset or avenue but also the risk one is willing to take. An investor’s ability to take risk includes the investor’s time horizon, need for liquidity and risk capacity. These factors determine investor’s ability to cope up with the financial vagaries reflecting in their portfolios. While the first two factors simple to understand, the risk capacity is the financial capability of the investor to withstand a financial loss without compromising desired standard of living.

This is evaluated by assessing the total investable assets relative to net worth and the amount of assets or income available at disposal to cover for future unexpected liabilities. These could be buffered by insurance and exigency fund allocations. However, these quantitative analyses only possibly provide a range of investment outcomes that an investor could prepare for but rarely addresses the behavioral issues which mostly drive an investment’s actual versus the desired outcome. The behavioral aspects could upset the most diligently drawn quantitative methods if not comprehensively covered for.

Risk tolerance on the other hand is the willingness to take risk. It represents the maximum amount of uncertainty an investor is willing to accept for a financial decision. This is inverse to risk aversion. In simple words, it’s the amount of risk the investor is willing to absorb remaining at peace or without losing sleep. The most influential factors considering risk profile of an investor are age, income, financial stability, dependency, goals, investment experience, current situation and psychological factors. While most of these factors are generic in nature, let’s look at how it would influence the loss tolerance of the investor.

It's usually assumed that younger investors have a high-risk tolerance as they have a longer time horizon to access their funds. But it doesn’t mean that all investment needs are same and so the attitude to them same. However, investors are better off looking at the investment decisions than that of viewing them in silos. This could hurt the portfolio construction and attain optimal returns for the risk taken.

So, the longer horizon of the younger aged investors allows them to have a longer rope (time) to recover from market-induced volatility in the short run. So, it’s ideal that young prioritise growth and thus invest in higher risk assets like stocks, etc. This could be at reversed as the same investor or those inching towards retirement could prioritise capital protection over growth of the portfolio.

A steady and consistent income allows investors to look forward and beyond. It provides a financial safety net and a psychological edge to take exposure to assets with higher risk potentially leading to higher rewards. Also, allows to avoid concentration of investments due to the higher liquidity available. Financial stability also allows the investor to think straight in times of volatility leading to better judged decisions.

Goals could alter the financial priorities and so is the dependency factors. A young working couple planning to begin a family would approach immediate future differently from those couples continuing to work in the immediate future. In the former, they might have to imbibe the possibility of one partner out of work or income for a period. This dependency would change the decisions for their other investments like a home purchase, etc. Aligning the investment strategy to these goals ensures an appropriate level of risk without compromising financial security. A seasoned investor would be comfortable to assess the risk associated due to the market volatility. They would have witnessed similar situations or cycles and so respond accordingly. The case is different for a rookie investor to digest the market swings and remain calm. Moreover, the current market conditions could shape our thoughts and hence cloud our decision making. In a bull market, investors tend to take higher risk than they could possibly recover from and in bear markets tend to turn more risk averse than they are.

The personality traits come to fore particularly during these episodes where a naturally risk averse investor pursuit of safety and stability outweighs the prospective higher returns leading to conservative strategy. On the other hand, a risk-seeking individual could find excitement in the possibility of higher returns at times disregarding the risk. Risk tolerance, hence is highly subjective aspect of financial planning and needs a thorough understanding to arrive at a comprehensive investment strategy.

(The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at [email protected])