How to know your tolerance towards investment risk?

To form your Investment Philosophy, you need a general idea about what Investment Risk is and what your tolerance towards it is. Once investors understand the types of risks involved, they can shape their investment process and overall portfolio to suit their appetite.

TABLE OF CONTENTS:

What is Risk Vs Return?

The definition of Investment risk can be defined as the probability or likelihood of losses relative to the expected return on any particular investment. Investment risk measures the level of uncertainty of achieving the returns as per the expectations of the investor. Risk is any uncertainty concerning your investments that has the potential to negatively impact you financially.

Investment risk comes in many forms, whether from market risk, company risk or the risk the investor poses on themselves. The lack of adequately measuring and managing risk can stop investors from achieving their long-term investing goals. When investors talk about Risk Vs Rewards the general understanding is that to obtain higher returns one must be comfortable with the increased level of risk.

Sometimes Investors don’t understand how to approach risk and what the appropriate level is. Every investor has a different risk tolerance made up of a few factors which we will discuss below. Having a general understanding of the levels of risk and the types of profiles can help you form a portfolio of financial instruments suited to your strategy.

Different asset classes and financial instruments all pose different levels of risk. The measure of risk (standard deviation) looks at each of the asset classes and shows how the hunt for higher returns also brings increased levels of risk. The rationale behind the Risk/Reward relationship is that investors willing to invest in riskier assets with the potential to lose capital should be rewarded for their risk.

Understanding investment risk and your risk appetite is the key to making informed investment decisions. When you invest there is always the chance that you don’t achieve the return you expect and the possibility of taking a loss.

The areas that make up Investment Risk.

Investment Risk refers to two terms, Systematic and Unsystematic risk.

Systematic Risk (also known as market risk) relates to the broader market of an investment and is caused by major events such as war, political instability, recessions, and pandemics. This includes the impact of inflation and interest rates.

Unsystematic Risk relates to the unique risks of a company or industry and is specific to each investment. This could come from a company taking on excessive debt, a competitor coming in, an industry disruption, brand damage, or board disruption.

Understanding the impact of both levels of risk can help investors gain a greater awareness of the market, the cycles, and the types of challenges to expect.

The table below outlines a lot of the risks investors face on a day-to-day basis. Some are unavoidable, others can be navigated with prudent due diligence, research and a handle on your behaviour.

Investment Risks that can affect returns include:

TYPES OF INVESTMENT RISK:WHAT IT CAN IMPACT?
Interest Rate RiskChange in interest rates impact investment returns positively or negatively. Rising rates impacts the stock market and vice versa.
Inflation RiskInflation may exceed the return you receive on your investment diminishing long-term purchasing power.
Market RiskAn investment falls in value because of economic changes, a change in the market cycle or other events that affect the entire market.
Sector/Industry RiskAn investment falls because of events that affect a specific industry sector, such as cyclicals, minerals, mining and clean energy.
Currency RiskForeign exchange rate is impacted by factors such as local interest rates, inflation, politics, trade levels, and government debt. Foreign currency fluctuations.
Liquidity RiskYou can’t offload your shares and get your money out when needed without impacting the price in the market. (Small-Caps).
Financial RiskThe ongoing ability of the company you invest in to meet its financial obligations is a common source of investment risk.
Operational RiskThe risk from companies that make crucial mistakes in planning and executing their strategy, or diversifying acquisitions too much.
Management RiskThe risk that individual investment managers underperform. The board are not aligned with shareholders and poor capital allocation.
Timing RiskInvestors trying to time investment decisions that expose you to lower returns or loss of capital. Timing markets and positions.
Leverage RiskInvestor’s using leverage to invest, not understanding the additional layer of risk it brings. Forced selling to repay back debt.
Competitor RiskThe company you invest in has a serious threat, losing market share and lacking a competitive edge over the competition.
Diversification RiskOver-diversifying or being too concentrated in your portfolio structuring. Too concentrated on a single position or sector.
*This is just a short list of the types of risks that investors face the most. (Excluding Behavioural).

A look at Risk Tolerance profiles.

Once investors have a general idea of the investment risks exposed to them it is important to then gauge the profile they may fit into. Knowing your comfort level with risk will help align you with the best investment options to suit your investing objectives.

Investments that have the potential to generate higher returns are riskier. Therefore, you need to decide how comfortable this trade-off between risk and return is.

The above illustration shows the mindset behind the 5 risk profiles. The age is not a necessity but rather a guide. The general theory behind investing is if you are young you can afford to risk more as losses can be regained. Capital appreciation should be the primary focus. As you get older, your risk profile changes. Income becomes important and protecting capital is essential. I believe risk comes down to the investor as opposed to the age.

Once an investor falls within a certain bracket their asset allocation and portfolio construction will revolve around their risk tolerance. Let’s consider the first graph showing the correlation between Returns and Risk. A younger more aggressive investor may start at the very right-hand side at the top. Having a 100% allocation to stocks. As they get older, they come further down the line and may balance a portfolio of 50% stocks and 50% bonds.

This is where Portfolio Management and Asset Allocation strategies come into play. Such as, Core/Satellite or SAA (Strategic Asset Allocation) and TAA (Tactical Asset Allocation). A portfolio will be designed around the risk tolerance levels.

Defining your tolerance towards Investment risk.

The risk profile of investors is important as this will often drive their investment process and how they build a portfolio that aligns with their investment philosophy.

An investor’s behavioural traits, lifestyle, and age are some of the key factors to consider when building an investment portfolio around your risk tolerance. Each investor has a unique risk profile that determines their willingness and resilience to withstand risk.

Once investors understand the basics of risk with the different investing styles, investors need to ask how they feel about risk.

Here are some areas to consider when determining your risk tolerance.

Time Horizon | Are you still early in your investment journey or are you ready to retire? Can you afford to take on risk or need to consider safer alternatives? Do you have a long compounded time frame ahead?

Income | Do you have income stability? High debt levels? Can you afford to take on risk? Will you be better at dollar-cost averaging? If you don’t have stability don’t be so aggressive!

Responsibilities | This is about personal obligations, do you have a family to provide for or are you single? Buying a home? Do you have the freedom to take on more risks?

Tolerance for Risk | Are you a risk-averse person or do you love to take on risk? Are you conservative by nature or can you handle setbacks? Do you plan or roll the dice? Know your risk tolerance.

Financial Objectives | Whether it is to buy a home, retire young, or put a child through school? What are your goals? Short and Long-term. The time frame of goals will create very different risk outcomes.

How does behaviour affect Investment Risk?

Behaviour is a very important part of assessing risk. How you handle loss and setbacks will drive a lot of how you invest long-term. How would you feel losing 30% of your portfolio tomorrow? What about 50% on your largest holding? How about the banks calling in your margin loans and you liquidate at a loss?

Investors spend so much time on portfolio structuring and β€œBeta Average” spreading positions and tinkering without considering the impact behaviour has.

If the thought of a 3rd of your portfolio, and in effect your net worth, dropped and that made you sick, your answer is right there. If your current portfolio were to take a hit in a down market, could you stomach the loss or would anxiety and stress creep in? A lot of naturally Stoic investors still go by the β€œIf I can’t sleep” I’ve taken on too much risk analogy.

No one likes to take a loss, period! However, some are a lot more resilient at handling it than others. They know the price of higher returns comes with the added risk exposure.

Investors can reduce their exposure to risk by prudent asset allocation and for most, diversification. The spreading of unsystematic and systematic risk is what the majority of investors should practice. Finding asset classes that don’t correlate across multiple investments, currencies and instruments can create a diverse portfolio to suit most risk appetites.

In Summary…

So, in summary, what do I think about Investment Risk?

I believe the most important factor (in combination with the other risks) is inexperience and investors not knowing what they are doing. If investors are time-poor, then that also contributes to how they must accept lower returns for less risk.

Obtaining higher returns and lowering your exposure to risk takes time, experience, commitment and above all, handling your behaviour. As your experience and knowledge grow you may view risk in an entirely different way.

Yes, systematic, and unsystematic factors expose every single investor to some form of risk. However, I believe investors who are prepared to do the work, can venture higher up the β€œStandard Deviation” line whilst still minimising risk.

Having a sound investment philosophy that guides your strategy and process is often an overlooked contributor to minimising risk. Due diligence, prudent stock selection, analytical capabilities, and an intimate knowledge of your holdings can help reduce risk where others may be exposed.

As an active stock picker, nothing ventured nothing gained is how I invest.


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