WEALTH CREATION: Investors need to realise what is the risk they are willing to take and can afford to take for earning optimal returns
The two sides of any investment are the risk aspect and the return aspect. While returns are easier to understand, it is risk that is a lot more nuanced. How do we define risk? Risk is the probability of occurrence of a bad outcome or non-occurrence of a good outcome. Therefore, risk is always relative and not absolute.
When it comes to stocks, risk is measured using the standard deviation of returns also called volatility in popular parlance. But it looks at risk from the perspective of the investment product. The bigger question is what is the kind of the risk the investor is willing to take and what is the risk she can afford to take. This forms the basis of the distinction between risk capacity and risk tolerance.
Risk capacity or risk tolerance
For investments, risk capacity matters more than risk tolerance. Risk tolerance is subjective in the sense that it is more of an emotional representation. The risk tolerance differs from person-to-person. It has a lot to do with mental make-up. Some individuals tend to panic at the first sign of risk while others have the capacity to withstand higher degrees of risk without even batting an eyelid.
The key question is whether a person with higher risk tolerance should take on more risk? That is where affordability of risk comes in and that is measured by risk capacity and not by risk tolerance.
Risk capacity is a lot more objective. Risk capacity stems from factors like personal net worth, deep understanding of markets and exposure to asset classes, etc. That is what puts fund managers and High Net worth Individual investors at a higher pedestal when it comes to taking on higher risk in the investment process.
The golden rule is that asset allocation must be driven by your risk capacity and not by risk appetite. The risk you can afford to take is more important than the risk that you are willing to take.
Which is more relevant
From a financial planning perspective, risk capacity is a lot more relevant than risk tolerance. For example, you may have a risk tolerance for seeing 60% depreciation in your portfolio without flinching. However, that is your risk tolerance / risk appetite. That is not your risk capacity. Risk capacity is a function of a variety of factors like your age, your income level, your liabilities, your upbringing, etc. Risk capacity is about how much risk you are capable of taking and therefore it lays out how much risk you should be taking. Your future financial plan is about leveraging the power of compounding to allocate assets so as to efficiently meet your goals. Be it creating your portfolio or monitoring the portfolio; the driving consideration should be your risk capacity only. Your debt-equity mix, your liquidity commitments and your risk-return trade-off will all depend on your risk capacity. This is your major takeaway! When we talk with reference to risk in investment parlance, we are always referring to risk capacity and not to risk tolerance/risk appetite.
Understanding the interplay of risk tolerance and risk capacity
Remember that in the final analysis it is the interplay between risk tolerance and risk capacity that best defines your portfolio matrix. The graphic captures the interplay between risk capacity and risk tolerance.
As a prudent investor, you don't have to take on risks just because you have the risk capacity, just as you don't need to take on risk just because you have higher risk tolerance. Let us finally break up the above chart into four quadrants.
Top-right qaudrant represents investors who are really successful as investors or entrepreneurs. That is where real wealth in the world is concentrated
The top left quadrant is where most of inheritors are concentrated. Their role is normally restricted to keeping risk low and protecting the principal
The bottom right quadrant is the high-stakes gamblers. They are better off in a casino or at the race course rather than investing their money in financial assets
The bottom left quadrant represents most retail investors who don't have risk capacity and also don't have the risk appetite and their wealth growth is constrained
The writer is vice-president-head of research and ARQ, Angel Broking. The opinion is that of the writer and is for reference only
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