Unlock Your Investment Potential: Understanding Risk Tolerance, Ability, and Need

Understanding risk is critical to successful investing, but it's more nuanced than just fearing losses. This article breaks down how to determine the right level of risk for your portfolio by considering your personal risk profile. According to the sources, it involves assessing your behavioral loss tolerance, your ability to take risk, and your need to take risk.

 

Behavioral Loss Tolerance: More Than Just Gut Feeling

Behavioral loss tolerance refers to your psychological comfort with market volatility. It's about how well you sleep at night, knowing your investments might decline. This isn't a fixed trait but is composed of six key elements:

• Risk tolerance: Your general willingness to engage in uncertain financial behavior.
• Risk preference: Your inclination to take more or less risk in general.
• Financial knowledge: Your level of education, training, and experience related to finances. Higher financial knowledge typically leads to a greater tolerance for risk.
• Investing experience: Your experience with investing, which can increase your comfort with risk.
• Risk perception: Your subjective assessment of the riskiness of investing, separate from the objective reality, and it is often influenced by external factors like media.
• Risk composure: Your behavior during market downturns, which can only be truly known by living through market declines.

It is important to realize that risk tolerance is personal and best assessed with a reliable psychometric questionnaire. These questionnaires, which can be found online, provide a score that ranks you relative to others who have taken the assessment. This means that the results place you on a scale relative to a relevant population, and while it will tell you how risk tolerant you are compared to other people it won't tell you how to invest your money. Interestingly, men tend to overestimate their risk tolerance, while women tend to underestimate it. Similarly, younger respondents and those with a graduate education have been found to overestimate their risk tolerance.

 

Risk-Taking Ability: Can You Afford to Take Risk?

Even if you have a high behavioral loss tolerance, you must consider your ability to take risk. This means understanding your capacity to withstand declines in your portfolio value without compromising your lifestyle. This ability depends on three main elements:

• Time horizon: The length of time you have before you need the money. A longer time horizon typically allows for higher risk-taking ability.
• Liquidity needs: How often you need to access funds from your portfolio. If you require regular withdrawals, your ability to take risk is lower.
• Capacity to absorb financial loss: The ability to withstand financial loss without impacting your standard of living.

Your human capital, your ability to earn income also affects your risk-taking ability. Stable employment allows for more risk with your financial assets.

 

Need to Take Risk: What Do You Need to Achieve Your Goals?

Finally, assess how much risk you need to take to reach your financial goals. If a lower-risk investment can achieve your objective, there's no need to take on more risk. Conversely, if you need a very high rate of return to meet your goals, it may be better to revise the goal rather than taking on excessive risk.

Risk Over Long-Term Horizons: Shifting Perspectives

The perception of risk changes over time, especially for long-term investors. While stocks are more volatile in the short term, their higher expected returns and ability to outpace inflation make them potentially safer in the long run. Some studies suggest that even for retired long-term investors, higher equity allocations are more optimal.

Taking the Right Kind of Risk

It's also crucial to understand that there are different types of risks. Speculating on individual stocks or industries is not a compensated risk because they don't guarantee a positive expected return. Instead, focus on compensated risks, such as increasing your allocation to a well-diversified portfolio of stocks, allocating to riskier stocks like small-cap stocks, and other well-established expected return premiums.

Understanding your personal risk profile and the nature of risk at different investment horizons is essential for building a robust, long-term investment strategy. Balancing your behavioral loss tolerance, your ability to take risk, and your need to take risk will guide you in choosing a portfolio you can stick with even during challenging times. Remember, the best portfolio is one you can stick with, and that might not necessarily be the most aggressive or conservative one.