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Investing: What's your risk tolerance? - Views on News from Equitymaster
 
 
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  • Sep 15, 2005

    Investing: What's your risk tolerance?

    From the Finance Minister and the SEBI to the local broker, all governing bodies, intermediaries, participants and advisors are leaving no stone unturned to display their levels of comfort with the current market valuations. No one, however, seems to be bothered about the fact that 'level of comfort' is not a universally common phenomenon, but varies from individual to individual depending upon his/her risk profile.

    In fact, the risk profile of a retail investor is distinct from that of high networth individuals or institutional ones. It is thus pertinent for an investor to judge his/her positioning on the risk return matrix before going ahead with the asset allocation.

    Risk-reward concept
    You might be familiar with the risk-reward concept, which states that the higher the risk of a particular investment, the higher the possible return. This is a general concept underlying anything from which a return can be expected. Anytime you invest money into an asset (here meaning investment) there is a risk, whether large or small, that you might lose money or not get anything back. In turn, you expect a return, which compensates you for bearing this risk. In theory, the higher the risk, the more you should receive for holding the investment, and the lower the risk, the lesser are your dues.

    Determining your risk profile
    With the varied investment avenues available to choose from, how does an investor determine how much risk he or she can handle? Every individual is different, and it is difficult to create a steadfast model applicable to everyone. However, one should consider the following aspects to determine the individual's risk profile.

    • Demographic profile: Age, stability of income and access to varied investment avenues (depending on literacy and place of residence) are some of the demographic segmentations that one should evaluate. Higher age, lower stability of income and lesser access to investment avenues (and related information) put an individual in a profile, which calls for investment in 'low-risk' assets.

    • Liquidity: Liquidity requirement or, in other words, longevity of the investment is another critical parameter to be looked into. Investors requiring higher liquidity are better off staying away from high-risk investment. 'Stocks are a safe bet, but only if you stay invested long enough to ride out the corrections,' said Peter Lynch. Thus, investors looking at short-term avenues need to categorise themselves in the profile which calls for investment in 'low risk' assets.

    • Rate of return expected: Equity investments are suitable only for those investors who are ready to take higher risk thus expecting returns more than what is provided by low-risk assets like debt and fixed deposits.

    Investment risk pyramid
    After deciding on how much risk is acceptable in your portfolio by acknowledging the above parameters, you can use the risk pyramid approach for balancing your asset allocation. This pyramid could be used as an asset allocation tool with the help of which investors can diversify their portfolio of investments according to the risk profile of each security. The pyramid, representing the investor's portfolio, has three distinct tiers:

    • Base of the Pyramid: This area comprises of investments that are low in risk and have foreseeable returns. It should desirably compose the bulk of your assets if you are a risk-averse investor.

    • Middle Portion: This area is made up of medium-risk investments that offer a stable return while still allowing for capital appreciation. As they are more risky than the assets creating the base, these investments suit investors having slightly higher risk tolerance.

    • Peak: Reserved specifically for high-risk investments, this should ideally comprise the smallest proportion of an investor's portfolio and should be fairly disposable so that the investor does not have to offload it prematurely in instances where there are capital losses.

    Check whether the returns expected match your risk-taking capability! We believe that investors would be well off if they correctly determine their 'risk tolerance' before making their allocations.

     

     

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