As investors, we always tend to worry about what might go wrong in our portfolio regardless of how much efforts of research we’ve taken.
There’s always this navigation on how things might not perform up to our expectations because of the underlying differences between our risk appetite and risk tolerance that we can take from the whole risk universe we are exposed to.
Many investors put their whole resource perspectives on how to improve performance but do not spend enough time evaluating their risk tolerance.
The business of investing is inherently about taking risk to generate a return. It is the same inherent risk when we are trying to cross the road by waiting for the traffic light. There are some who get to the other side faster by dashing onto an ongoing traffic, while there are some who would patiently wait for a signal before crossing the road.
From an investment perspective, it is precisely why the capital asset pricing model advocates the premium return an investor needs to generate when they are undertaking additional risk in the form of a risky asset, whatever that asset is.
Going back to the original intention of the article, I wanted to articulate through what has been covered through the whole risk universe we are exposed to and how we can navigate our understanding on the risk tolerance and risk appetite better.
The Risk Universe is a central repository of all the generic risks that have been added to the component to make up the maximum and minimum units of performance over time.
This includes both the Systematic risk and Unsystematic risk.
An unsystematic risk is also known as the specific type of risk within the organization that an investor can overcome by understanding the company better through deep-dive and scuttle-butting the management. An investor can also overcome unsystematic risk through diversifying into different companies or industries or to a certain extent different form of assets. A systematic risk however, is an unknown factor that an investor has no control of regardless of how much efforts he has done on his research. These are mostly impacted by black swan event which we are not expecting it to come.
The Risk Tolerance should be a subset of the risk universe. They are the conscious level of determinant of the maximum unit of risks that a person is willing to undertake to achieve a corresponding level of performance. Going back to the analogy of investing, this determines an investor’s understanding of the ability and willingness to stomach large swings in the value of the investment. You would also note that from a psychology point of view, most people would correlate their risk tolerance to the maximum amount of losses they can take. After all, no one likes to lose money, not at least in the mind.
Last but not least, we moved to the Risk Appetite, which should form a smaller scale of the risk tolerance. Most people connects their risk appetite to the performance benchmark they need to fund for their needs. For instance, a retiree that requires 4% returns on a $1m portfolio would usually benchmark their risk appetite accordingly to generate the returns that they need.
The reason why it is difficult to advocate financial planning and investing to a stranger is because we have no idea on how much risk tolerance and risk appetite they can take. Sometimes, we assume we know but we are not sure ourselves where exactly our risk appetite is.
The problem exists when we scale up our risk appetite and thinks the same can be scaled up with our risk tolerance. It doesn’t work that way but subconsciously we may be forced to think the risk tolerance and risk appetite all moved up one level accordingly. This usually happens when we are over confident about things and think our mind and body can take a lot more tolerance before the reality strikes.
If you like the articles, you may follow our Facebook Page here.