What is Your Risk Tolerance?
At 60 years old, a couple of years before retirement, my dad asked me: “Do you think I should just put all my savings in Bitcoin, it’s gone up so much, seems like everyone loves it and profits a lot?”. Oftentimes, we cannot see our own irrational optimism. Like hoping that we can compensate in a year or two for missed wealth accumulation opportunities of over 40 years by betting on an ultra-risky portfolio, or worse yet, a single risky asset. It may or may not pay off, of course, but is that the rational thing to do, if you consider all potential outcomes? If the asset has the ability to crash over 40% in price 9 times within a 10-year period, can you, given your current stage of life, circumstances, and goals, take such a loss (or multiple losses)? That is precisely why you need to know how much risk you can — and cannot — afford to take.
Know yourself before you start risking your money
The content of this post does not constitute financial or investment advice. It is intended for information and education purposes only.
You can also read this article on Medium
Think of it as your ability to handle pain
You would have a difficult time deciding which investment instruments are suitable for you, without knowing what your goals are, as well as your constraints and needs. But perhaps the most essential input, and the most difficult to objectively assess, is your risk profile. It is essentially the intersection of your ability to withstand and/or recover from financial losses, how much risk you need to take to achieve your financial goals, your willingness to take it, and your propensity to react in different ways to it. But using such unnecessarily formal summaries is kind of boring and, frankly, not the best way to approach this topic if you are a DIY (i.e., do-it-yourself) beginner investor. So let us think of it from another perspective.
Pain. Medically, everyone has a different tolerance for it, which depends on many factors — one’s age, genetics, gender, personal experiences, physical and mental fitness, pre-existing conditions, etc. Pain can occur suddenly and unexpectedly or it can be caused by a predictable/known event. It can be chronic, neuropathic, acute… Portfolio losses are an investor’s financial pains. And just as doctors try to gauge a patient’s pain magnitude (e.g., by using a 1–10 scale), financial advisers use various metrics and methods to get a specific measurement of investors’ risk tolerance.
Unfortunately, the tools they utilize are very far from perfect — as is the “patient”. There is a whole range of questionnaires available to professionals and even to individuals for self-assessment, but they are usually flawed and over-complicated. I must admit, I also use such a tool, simply because it is useful in gathering important information. But these tools ask questions about situations and scenarios that you are usually not experiencing at the time of answering. Hence, your actions and reactions are likely to differ when real stress events take place, and your nerves and biases are being truly tested. If you are asked about hypothetical pain, you can rationally consider what is the appropriate answer; however, if you actually are in pain, it is likely your reaction will be much more instinct- or emotion-driven than that.
A simple self-assessment in a calm environment
There are aspects of your risk profile that you can gauge in the comfort of your own home or with your adviser, without the impending risk of losing money hanging over your head. You should just keep in mind that it is not a fully realistic assessment and your answers will be a function of a much less tense environment. However, this kind of mental exercise still has benefits — as it allows you to look a lot more comprehensively (and rationally) at the problem from many different perspectives. Something you would probably not be able to do if you were just about to lose millions, for instance.
You can begin by asking yourself the following questions:
– What are my age and my investment horizon?
This is one of the key constraints for individual investors which limits how much risk one can take, how much time is left to recover from losses, and even what limitations exist in terms of liquidity. It is also linked to the goals and objectives one has set. Additionally, it is key from the perspective of the so-called human capital — i.e., the value today of future expected labor income. As people work and earn income, they convert their knowledge and skills into financial capital. But as we age, generally human capital dwindles (although there could be exceptional cases, but they are not the rule). So we approach a moment when financial capital makes up most of our wealth, hence the importance of growing it. Also, as we approach retirement, we have less and less time to recover from financial mistakes. So ultimately, all else being equal, risk tolerance and risk capacity would be greatest at younger ages and with longer investment horizons, and lowest when you get to retirement age (or older).
– What are my financial goals?
The answers to this one could vary a lot. And many people have multiple financial goals, sometimes competing for priority. For instance, a family might want to buy their own home, while saving for retirement, investing for wealth accumulation and repaying student debt. But knowing all this is quite critical as it determines to what extent taking on risk is acceptable, and beyond which point it is too much. That is why this is the first step in a financial planning process — and is linked to all other aspects, including age and investment horizon, as each financial goal comes with its own timeline. For some, their financial goals could involve very aggressive growth of their investment portfolios, which could mean they need to take on more risk. For others, regular stable income could be the main objective, in which case the risk could be much lower. You can read more on the importance of goals and how they influence your financial decisions and planning right here.
– How big a loss am I willing to tolerate and from how big a loss can I recover?
This is a question of both psychology and resources. If I know more about markets and the economy, if I have sufficient ‘firepower’ and buffers, and if I know that my portfolio is well diversified — I am more likely able to tolerate bigger losses. Why? Because I would be able to see what could come next in the market and policy cycle, and be able to position my available capital so I can recuperate what I might have lost.
– Do my circumstances allow me to expose myself to more risk, or not?
Circumstances include, for instance, your current financial situation and existing portfolio, family situation and life-cycle stage, liquidity needs and constraints, income utilization and savings rate, etc. You could have a portfolio that is already very concentrated in financial stocks, for example. In this case, you have already taken on risky exposure in one area, and you need to find a balance in your next investment choices. You might need cash very shortly for a large purchase or a house renovation, in which case you might need to keep liquid buffers or at least invest in more liquid assets that you could sell on short notice without the risk of losing a lot in the process. Therefore, your circumstances can extend your tolerance and capacity for more risk in your portfolio — or they can constrain it.
– Am I mentally prepared to deal with the surprises and shocks in global financial markets?
Everyone should approach the topic of investing with the right mindset — i.e., having accepted the clear fact that financial markets are volatile and that taking risks is necessary to earn a return on any investment. They are sensitive to what happens in the broader economy, to changes in market sentiment and risk appetite, to herding behavior and irrational biases, and to geopolitical and geoeconomic events. You are guaranteed to experience unexpected dynamics that could put you far out of your comfort zone and if you believe this is too much for you, then you might have low tolerance for risk. On the other hand, if you have gone through something similar in the past and handled it calmly, without letting fear and emotion drive your decisions, then you could be able to tolerate more risk. Your knowledge and experience, as well as your qualities, emotional state, personality and biases will play a role in determining which group you belong to.
– Can the consequences of losing my investment portfolio devastate me?
Take my father once again as an example — his goal is to invest for retirement, with a relatively short time horizon. If his plan to profit from Bitcoin fails and instead he loses, say, 50% of his portfolio, what will be the consequences for him? His retirement will likely be ruined, with very limited ability to recover from the loss and obtain sufficient income and assets to provide for his spending during this next stage of his life. Such a risk is unacceptable to him, and hence, his risk tolerance is in reality much lower than the idea he was considering.
One of the ways of showing the results of the assessment that I find most useful is with a radar chart. Assuming you can score each component on a 1–10 scale (10 referring to the answer linked to the highest tolerance for risk), the resulting chart could look like the ones below. The larger the shaded surface area, the higher the risk tolerance. Aggressive, moderately aggressive and conservative allocations refer to whether risky assets (such as riskier equities, alternative assets, crypto assets, etc.) will have a relatively higher share in the portfolio or not.
A realistic self-assessment under stress
I think a proper real-world test of risk tolerance is actually trying to invest. That is why I usually suggest to people (when it is fitting for them), that if they want to check how they would act in a more realistic setting, they could just open an account, select suitable investment products aligned with their goals, etc., and see what happens when markets move. You can do it with a demo account (although that is not as realistic) or with a real one with a smaller amount of money. The goal is to feel how the value of your holdings fluctuates and observe how you behave when there are more significant (even extreme moves) or a prolonged period of unfavorable moves. You will likely make mistakes, but you will also learn a lot — including tons about yourself, which will later help you invest more confidently:
- Can you handle the stress, especially when there is turmoil?
- Can you keep a long-term perspective, or are you tempted to look every second and obsess with ‘where is this going’?
- Can you tolerate a loss, or does the fear make you react irrationally and impulsively?
- At which point does your ability to keep cool and avoid emotional actions end?
- Do you resort to selling after the market goes up for a while or after it goes down for a while? Why — how do you motivate yourself?
- Do you feel like most or all of the moves that happen are incomprehensible to you? Do you think you might need more education or experience to understand better how and why things happen?
- Are you influenced by what others are saying or doing?
My personal view is that the self-assessment under stress does a better job at gauging your behavioral and psychological fitness to handle your market exposures, while the traditional risk tolerance tests (or better yet, a full financial planning profile) are better at establishing the objective parameters that allow or constrain the level of risk you can afford to take. So it would be a good idea to make a judgment based on both.
CONCLUSION
Having a more comprehensive idea of your personal risk profile is an essential piece of knowledge for making any financial decisions, including investments. But it usually involves a complex and imperfect assessment process that could try too hard to quantify something that is not really measurable. Using a financial planning preparation is, in my view, a much better way to gauge the risk profile than the simple standardized tests used by most institutional intermediaries. But in addition to that, a critical component is the behavioral and psychological part of risk tolerance, which is more accurately gauged with practice and experience in real-life situations.
REFERENCES:
1. Grable, J., RiskCAT: A Framework for Identifying Maximum Risk Thresholds in Personal Portfolios, Journal of Financial Planning, 2008
2. Grable, J., Financial Risk Tolerance: A Psychometric Review, CFA Institute Research Foundation, 2017
3. Hubble, A., et. al., Investment Risk Profiling, CFA Institute, 2020
4. Menkoff, L., et. al., Risk Attitude Assessment, DWI Economic Bulletin, 2016
Author: Nikolay
Founder of MoneyCraft
