Risk tolerance vs risk capacity
How much risk are you willing to take?
When it comes to investing, risk cannot be ignored. That being said, more investors place much more emphasis analyzing past performance than risk and quite often, risk is ignored altogether. If understanding risk is so important, then why do so few people take the time to understand it?
Like it or not, the investment industry is a fickle one. It is an industry that is full of sexy messages like get rich quick, make money fast and high returns. Over and over again, research supports that investors tend to chase performance putting their money into the investments that did the best and are doing the best. Unfortunately, this strategy has also proven to fail miserably. How do we overcome this inner desire to chase performance? How do we fight the urge to buy last years winners hoping they will be next years winners? How do we look past just performance and returns? The answer lies in understanding risk
Two dimensions of risk
When it comes to understanding risk, we need to look at the two dimensions of risk. The two dimensions of risk are investment risk and investor risk. Investment risk is the risk traits and characteristics of an investment. Investor risk lies in the head and the heart of the investor. It is internal and I sometimes call it the sleep factor. Let’s look at these two dimensions of risk in a little more detail.
How do you measure the risk of an investment? The investment industry uses statistical measures to define risk. The industry looks at things like standard deviation, beta, drawdown risk, and frequency of loss, downside risk. The fundamental problem with risk measure is they tend to be harder to find and fewer people understand them. Think about it, if you want to find the 1, 2, 5, 20 year returns of a specific mutual fund, I bet you can find that data pretty quickly. On the other hand if I asked you to find the betas, alphas and draw downs of a group of mutual funds, many would fail, some would find it but it would take them a lot longer. Personally, I think this is one of the shortfalls of the investment industry. There is too much emphasis on returns and not enough information on risk. I understand why. Performance is sexy and sells.
Investor risk – tolerance vs capacity
When we look into the head of investors to try to understand risk, we need to talk about the difference between Risk Tolerance vs Risk Capacity. Risk tolerance is the amount of risk you WANT to take. Risk capacity, on the other hand is the amount of risk you NEED to take.
The problem today is that Canadians risk capacity is usually not the same as risk tolerance. Most people have a lower risk tolerance than what they need as a risk capacity. Most retirees will need to take more risk than what they want. In fact, they can’t afford not to take risks.
Studies today are showing that being too conservative can have big risks in a low interest environment. With inflation, longer life expectancies and low interest rates, many investors (especially boomers and retirees) will need to worry about longevity of asset risk – outliving your money.
Matching your risk
The first step is to take the time to understand your personal risk tolerance and risk capacity. This will require some self discovery and general financial planning. If you are not sure how to do this, any financial advisor should be able to sit down with you and with some questionnaires figure out your risk tolerance and risk capacity.
What is more important, however, is to make sure that investor risk matches investment risk. That also means that you will need to take some time to understand investment risk and how much risk there is in any investment. Over and over again, we see the patterns where investors buy investment with great returns or great potential returns without taking that time to understand risk. Unfortunately, most investors who place too much emphasis on return and little to no emphasis on risk, get burned. The rule is simple, risk and return go hand in hand. The higher the returns, the greater the risk. The lower the risk, the lower the returns.