“Never take more risk than you have the ability, willingness or need to take,” -Larry Swedroe
Most of the people are ready to take the risk because of their inherent nature, positive attitude towards life, finance domain and knowledge of financial products etc. Irrespective of the fact that, whether they are able to take risk or not, their current financial situation and milestones would decide to take risk or not. You can be very much a risk taker, may lead to a situation where you are not able to meet your financial goals. On the flip side, your low risk profile may also not be able to achieve your goals at the first place. Now the question raises hands how much should take the risk while investing whereas both over-risk and under-risk may pose bad situation either ways.
For example, you may be able to take a fair amount of investment risk if you won’t need the money for a long time and have a steady, good-paying job. On the other hand, you may need to take some risk to generate returns to meet your goals. An all-cash portfolio may feel safe, but it likely is inadequate for long-term needs.
So what factors should ideally decide your risk taking ability is the importance and seriousness of your milestones for which that particular investment is to be done. There is need to be considered all three factors separately (ability, willingness and need to take risk) and choose the least overall amount of risk consistent with them.
The willingness to take risk means how likely are you to get panic when your portfolio loses value, as it inevitably will? A common test for willingness to take risk is the “sleep test”. If you can’t sleep at night because of an investment decision, either actually made or in consideration, then you may have exceeded (or are considering exceeding) your willingness to take risk. On the other hand, if your decisions do not cause you unrest, your investments are probably in line with your willingness for risk.
Thus, willingness to take risk reflects your level of comfort with loss of your investment.
For instance suppose you’re considering investing Rs10,000. Your willingness for risk is how readily you would take the chance of losing some of it for the chance of earning an expected profit. For example, you might not be comfortable taking the risk of a 50% probability of losing Rs5,000 (half the principal) in exchange for a 50% probability of earning Rs10,000 (doubling the principal). But, perhaps you might readily risk a 25% probability of losing half for a 75% probability of doubling it. Your willingness for risk is exceeded in the first example but not the second. Thus, the willingness to take risk depends on your psychological makeup.Read: Look at Value or Price of Product?
Ability to take risk means to be able to take risk you have to have something you can afford to place at risk. It depends on your time horizon, the stability of your income, debt, your surplus money i.e. your income less all necessary and regular expenses and high relative to your financial goals. Having appropriate size of an emergency fund and no-high interest debt are leveraged your ability to take more risk as it is quantifiable rather than your willingness for risk may be vague.
Investment Funding Level
Another area to consider is your investment funding level. Ironically, many investors’ emotions lead them to peruse more risk when they are underfunding their investment as they are seeking more returns to make up for their inadequate investment. But they are not known, while underfunding their investment, their losses can easily jeopardizes their goals, which reduces their ability to take risk. In short, you cannot solve a funding problem by taking more risk.On the hand, investors who are adequately funding their investment may have a higher ability to take risk, because losses are less likely to upset their goals. However, taking on more risk may not be appropriate, if these investors are on track to reach their financial goals. In short, there is no reason to take on unnecessary risk.
Finally, all investors should consider their need to take risk. If your financial plan suggests you’ll need a 14% annualized return for 20 years to retire comfortably, you’ll need a significant allocation to equity. But if you’ve saved enough money to meet all of your financial goals, you might forgo all market risk and more skewed towards debt. Need for risk, more than anything else, drives one’s required asset allocation. In short, your need for risk is based on your future requirements for money. Some of these requirements are large and a long time from now (e.g. retirement) so pinning down their relationship with risk is tricky.
Taking a Risk the Smart Way
You have to learn how to balance the need to take risk, the willingness to take risk, and ability to take risk. Woe to those whose need is greater than their willingness or ability. Woe also to those whose willingness is greater than their ability. Happy is, he whose need is less than his willingness is less than his ability. Reduce your need and increase your ability.
When you have clearly identified the risk involved, you can plan and prepare to maximize your opportunities while minimizing those risks. How many people need returns higher than that to achieve their goals? If you take more risk than that, make sure you have the ability and the willingness to stick to your financial plan which gives direction of your goals will ultimately help you achieve goals you set for yourself and lead you toward success.
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Suresh K Narula is founder and Principal Financial Planner at Prudent Financial Planners. He has earned the professional CERITIFIED FINANCIAL PLANNER and got registered with SEBI as Investment Advisor. He writes on personal and financial planning
articles and got published in Dainik Bhaskar, Business Bhaskar and The Financial Planner's Guild, India. He is also a member of Financial Planner's Guild India ( An association of practicing SEBI registered Investment advisers) to create awareness about Financial Planning in general public, promote professional excellence and ensure high quality practice standards. Suresh received his an M.com from Himachal Pardesh University and an MFC from Punjab University, Chandigarh. He can be reached at email@example.com