What is Risk?
Wikipedia says that risk is nothing but the potential that a chosen action or activity will lead to a loss (an undesirable outcome). It also says that almost any human endeavour carries risk, but some are much more risky than others.
Consider the concept of risk, when we talk about finance. Financial risk is the probability that returns on your investments will be ‘variable’. This includes the outcomes that the returns can be better than expected (gain = good), and that returns can be worse than expected (loss = bad). To sum it up, risk is nothing more than a state of uncertainty, of more than one possible outcome.
When you invest, risk is inherent in almost everything that you do.
This is partly because there are so many types of risk – from market risk to interest rate risk to country risk and many more. The trick is to know 2 things, both of which are equally important.
First, which risks can you diversify away?
Second, how much risk can you afford to take?
Consider the first question: Which risks can you diversify away?
Diversification is nothing but reducing the risk to your portfolio by investing across different types of instruments that carry different levels of risk.
For example, your portfolio may be split across equity, debt, gold and cash.
Equity and gold tend to move inversely to each other. If you consider past data, you will see that in periods of economic uncertainty, when equity markets suffered and fell, gold has probably done very well. In 2008, when our own Sensex fell from 21,000 to 8,000 – one of the sharpest falls many of us had ever seen, gold and government bonds (debt) climbed by close to 30% in that same period.
So, you can diversify away your equity risks atleast partly by investing into gold and safe debt instruments.
For an investor with a diversified portfolio which contained gold, these periods of market trouble didn’t cause as much of a dent in the overall portfolio, as the dent caused in the portfolios of investors who had not diversified into gold. For the investor who had his child’s college tuition fees or any other life goal’s funds invested into equity before the market crash, and had no exposure to gold or not enough exposure to gold, this could not have been a time of many peaceful nights of sleep.
We all know that diversification is the intelligent thing to do, but not all of us do it.
This is odd because diversification in itself is very easy to do.
There is a simple rule to follow:
If you have a life goal (sending your child to college / putting the downpayment on a new house / your own retirement) that is less than 3 years away, try and avoid exposing these funds to equity market risk. Opt for debt (fixed income) instruments, and liquid funds to keep the corpus safe.
If you have a medium term horizon for your goals, that is – your goal is 3 to 5 years away, you can invest partly into equity, debt and gold. You can opt for up to 60% exposure to equity, 25% to debt and 15% to gold.
If your goals are long term (more than 5 years away), you can opt for an increased equity exposure of up to 70% to 75%, with up to 15% exposure to gold and 10% in debt.
Follow the simple structure outlined above, and your portfolio will be able to weather any turbulence the equity market brings your way.
Now on to the second question: How much risk can you afford to take?
This question has a very different answer to the one above. The first answer was almost standard. It gave general rules that can be tweaked to match a particular individual’s life goal scenario. This question however is asking you something personal about yourself.
How much risk can you, dear reader, afford to take?
This has nothing to do with your risk appetite.
You might love risk, you might be happy to live a life full of the thrill of taking a gamble, you might jump out of planes with a parachute strapped to your back in your spare time and thoroughly enjoy the experience – all of this indicates a high risk appetite.
Your (financial) risk tolerance however indicates how much financial risk you can handle without suffering financially.
Consider this very basic scenario to determine your risk appetite.
You make a bet with a friend. Your friend will flip a coin.
If the coin comes up heads, you win Rs. 500.
If it comes up tails, you win nothing.
If you choose not to flip the coin, your friend will simply give you Rs. 250 and the game is over.
The expected outcome in each of these scenarios is an average of Rs. 250. But depending on which option you choose, you know what broad type of investor you can be.
What would you choose?
If you are neutral between playing the game and winning Rs. 500, and not playing the game and winning Rs. 250, you are risk neutral.
If you choose to not play the game, and to just take the Rs. 250, or would take even less than Rs. 250 as long as there was no risk attached, you are risk averse. Seeing your equity portfolio fall is most likely going to make you uncomfortable.
If you would rather take the gamble, and in fact would take the gamble even for any amount more than Rs. 250, such as Rs. 300, you are a risk seeker.
But now consider your risk tolerance.
Consider these questions:
- What is your current financial situation?
- Do you have a majority of your life goals coming up in the short term?
- Do you have enough liquid cash in the bank to sustain your regular lifestyle for the next 6 to 24 months, without suffering, in case you lose your job or in case of any financial emergency?
- Do you have enough life insurance to take care of your loved ones in case something happens to you?
- Do you have a good health insurance policy to help you take care of any hospitalization expenses?
These questions and others like these will test your risk tolerance.
And it’s a combination of your risk appetite and your risk tolerance that you need to consider before you make any major financial decisions.
This is what a financial plan does for you.
A good financial plan will assess your personal finance knowledge, judge your reactions to hypothetical financial situations, test your aversion to risk against your ability to cope with risk, before deciding what your overall risk profile is.
It is based on your risk profile (tolerance plus appetite), your current financial standing and your life goals, that your investments should be structured in your financial plan.
So remember, it’s not just about how much you like it. It’s about how much you can safely handle.
Speak to your financial planner to understand more about your own risk profile – and you will be able to look at your past reactions to financial uncertainty and assess your own behavior better. This very simple exercise will make you a smarter, more aware investor.