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1 Simple Situation to Test Your Attitude to Financial Risk - Outside View by PersonalFN

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1 Simple Situation to Test Your Attitude to Financial Risk
Aug 22, 2012

There are many simple questions that can assess a person's general risk taking behavior. These will tend to cover risk appetite, but not often touch upon risk tolerance. These include even questions such as:

  • Have you at any time engaged in, or wanted to engage in adventure sports such as bungee jumping, sky diving, scuba diving etc?
  • Are your passengers always comfortable in your car with you driving or do you sometimes drive too fast or rashly for their liking?
  • Do you seek new experiences? Are you susceptible to boredom and seeking new ways to keep life interesting?
Answers to simple questions like these can help determine your risk appetite in life in general.

Now, consider this situation that will show how your risk appetite in life in general translates to your risk appetite regarding money:

Your friend offers you a deal. You flip a coin and if it comes up heads, you will win Rs. 200.

If it comes up tails, you win nothing, you lose nothing. You remain neutral.

If you decide to not play, your friend will give you Rs. 100 and the game is over.

Now, depending on your thinking, you will find one choice the obvious one.

If you are a risk seeker:
You will play the game. After all, it's a win-win situation. If it comes up heads, you make Rs. 200. If it comes up tails, you lose nothing.

In your mind, you reject the un-exciting option of making Rs. 100 for doing nothing, and choose the game instead.

If your equity portfolio falls during a period of market volatility, you are likely to buy more, without necessarily ascertaining whether the fund you are investing more into is a worthy fund or not, or whether your life goals are far enough away for you to add in more equity exposure to your portfolio.

If you are risk-averse:
You will not play the game. After all, it's win-win situation again. You are taking zero risk, not playing the game, and winning Rs. 100, guaranteed, for doing nothing.

In your mind, you reject the risky option of potentially making no money if the coin comes up tails, and would choose the guaranteed option of making Rs. 100.

If your equity mutual funds value drops during a period of market turbulence, most likely you will feel uneasy and could possibly make the classic mistake of selling low.

If you are risk-neutral:
Both the above situations will make sense to you, you see the benefits of both playing and not playing the game and would be neutral between the two.

Your attitude towards financial risk will be a large contributor to your level of financial health.

The more risk-seeking you are, the less healthy your financial portfolio is likely to be. However, it is also possible that if you combine risk-seeking behavior with the right research and advice, and you have a long enough time horizon to invest within, you will likely be wealthier, if not financially healthier, than a risk-averse person. This is, of course, within a common sense range of risk-seeking. An individual who actively and continuously takes bets is often nothing more than a gambler.

The more risk-averse you are, the healthier your financial portfolio is likely to be. It is likely that you will take calmer decisions, again, within a range of common sense, and will grow your wealth steadily, provided you have the right advice. And being risk-averse, it is also likely that you will seek out the right advice sooner than a risk-seeking individual.

If you would like to check your financial health, you can take the Financial Health Check created by PersonalFN.

Conclusion
Whichever type you are, one thing is common.

Your level of financial wealth will benefit from the right advice personalized to your own innate risk appetite. Your financial planner will be able assess your risk profile and explain to you how to go about building wealth keeping your risk profile in mind. Once you know what your profile is, you will also be able to assess your past financial behaviour and reactions to market movements, and prepare yourself better for any future volatility. This very simple exercise will make you a smarter, more aware investor.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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