Source/Contribution by : NJ Publications
Investors often misinterpret their risk taking ability or they may not be able to rightly communicate the same, and that's why it becomes imperative for the advisor to understand it on the client's part. Most times when you ask the investor about his risk tolerance, you'd get his Risk Appetite in response, that is how much risk he is willing to take and not how much he should take. Risk Appetite is the investor's attitude towards risk, it is a psychological factor. A number of factors influence the appetite or the willingness of the investor to take risk, some of them are:
The general nature of the investor determines his readiness to take risk. A bold and aggressive personality would be open to taking risks as against a timid person.
Secondly, someone with good prior Investing experience, would be more comfortable with risky investments as compared to someone who has had a bad prior investing experience.
Thirdly, product knowledge also makes a person amenable to a risky product, since he understands the underlying features and the risk return tradeoff.
A major driving force which can convert a pessimist into an optimist is the Market Sentiment. When everyone is buying, the most traditionalistic investor would pop out from under his quilt and be game for investing and of course, the other way round too.
Lastly, Age matters, young blood is more of an investment stuntman, because risk thrills him and moreover he has a major portion of his life lying ahead to make up for a wrong decision,
while the grey haired are cautious, since they cannot bear much volatility.
The above factors play a major role in influencing an investor's investing decision, yet it might not always be prudent. And the advisor has a crucial role to play here, the sum of the above, or the risk appetite is evident, you have to excavate the risk tolerance, that is the ideal risk taking ability of the investor. To arrive at the ideal risk-ability of the investors, you need to evaluate the following parameters pertaining to the investor:
Income: One, the advisor shall consider the income of the investor while evaluating his risk tolerance. The higher the inflow of money, the more risk the investor can afford. This is because a small pitfall will not pull the investor so deep that he's not able to stand up again. Along with income, take a look at the disposable income as well, if the investor has a high running income but equally high consumption, then the jolt from a risky investment can hit hard.
Age: Two, assess the risk tolerance with respect to age. Age is an element which affects both appetite as well as tolerance. A young investor has a leverage over an older investor and that's time. Time can heal the deepest cuts so even if the young investor suffers a loss, he has an entire life to recover from it and secondly, long time stabilizes the most volatile markets, it deletes the risk element from the investment. Therefore, a young investor has a high risk-ability as compared to his older counterparts.
Life expectancy of goals: Three, the advisor shall consider the distance of the goal for which the investor is investing. If the investor's goal is far enough, his risk tolerance is high, the investor should take risk and get the dual benefit of getting the maximum out of power of compounding as well as neutralize the volatility as explained in the above point as well. If the goal is short term, then volatility is capable of causing substantial corrosion to the Portfolio. This means your investor's risk tolerance will be different for different goals.
Financial Stability: Four, check for the investor's overall Financial Stability in determining his/her risk tolerance. Financial stability comes from the investor's level of preparedness, meaning if the investor has enough savings to take care of his liquidity needs, or meet any unexpected emergencies, he has a decent insurance backup, health, life and asset insurance, then he is considered financially stable. And such an investor can take more risk than someone who isn't prepared well. Because if risk poses a loss and there is a clash with an emergency, the latter investor would not be able to cope.
Dependents: Lastly, the number of mouths that the investor has to feed determines his risk tolerance. A person who has to take care of his two kids, spouse and parents, should be taking lesser risk as compared to a single investor or someone who has a working spouse and one kid to tend to. So, as an advisor it's important that you consider the investor's family stats before you attach risk to his Portfolio.
So, the above are some, among many factors which define the risk tolerance of an investor. There are various factors custom to a particular investor, that can play a role in determining the risk tolerance like expected inheritance, expected future earnings, etc., which need to be analyzed while assessing each investors Risk-ability. You must also remember that these are general ideologies and are not set in stone, these are standards which can have exceptions. There is a possibility that an old investor is financially stable, has enough assets and has secured his retirement. Although the age factor is not in the investor's favour yet the other factors negate the age, and allow him to assume risk.
Hence the above are subjective and interdependent and risk appetite too plays a major role here. No matter how tolerant the investor is, if he doesn't have the audacity, he won't able to digest risk. An investor may have a high risk tolerance but doesn't have the nerve to take risk, your job is to apprise the investor with what he/she is foregoing. Every investor must understand that returns come for a price, and the price is risk, and otherway round, there might be investors who have a low tolerance but a high appetite, so you need to apprise them with the potential risks. A balance need to be maintained. The bottomline is the Risk tolerance should be used in conjunction with the Risk Appetite of the client and the solution be applied in arriving at the Investment Strategy.
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