If you go to a party where you can eat any one food item, your consumption will depend on two factors – your willingness to eat (your intrinsic desire for the given item) and your ability to eat it (your appetite, food preferences, allergies, etc). If you are willing and able to eat the item, you would probably consume it in sufficient quantity and feel satisfied. However, if you are willing but not able (or able but not willing), then most likely you would remain unfulfilled.
Investment is done with the expectation of return. While ‘Risk’ is the possibility that the actual return may be different from the expected return. It is believed that higher returns can be earned by taking on more risk.
So, how much risk can you digest, to achieve “your” desired level of fulfilment? It depends on two factors – the ability to take risk & the willingness to do it.
Ability to take risk depends on various factors like age of the investor, life-cycle stage, number of dependents, the financial goal being targeted, the amount of disposable income (that is, surplus) available, etc. Individuals who are younger, unmarried, with no dependents, with high levels of surplus and who have non-critical or discretionary goals tend to have higher capacity of taking on risk than people on the other end of the spectrum (that is, people who are older, married, having large number of dependents, smaller surplus, with critical & non-discretionary goals).
Willingness (or desire) to take risk is more psychological. It’s a personality trait of the individual, that is independent of the factors stated above. Simply put, older individuals may be more willing to undertake risk than younger people, despite their age (or ability to take risk), because of their own unique risk-taking personality.
The decision to invest in a specific asset class or a combination of asset classes, therefore, will depend on a match between the perceived risk-return profile of the asset class and the investor’s ability-willingness to take the risk.
To sum it up, individuals must understand themselves first (from a “how much risk I can digest” perspective), before jumping into any investment decision, in order to avoid indigestion.
More about how to assess your risk-taking capacity in the next post. Until then. Signing off.
I wonder what happens when people who are unable to take risk have more risky taking personalities. Does that lead to bad investment decisions?
This is the most painful combination. Unable, but willing. Such individuals jump into risky decisions, without considering their ‘capacity’, usually resulting in undesirable outcomes.
For example, taking a big loan (that one cannot really afford) to dabble in stock market. Or trading in volatile shares by using funds earmarked for non-discretionary goals (like tuition fee).
Therefore, it is imperative to check risk capacity and tolerance for every investor.