What is risk tolerance?
Risk tolerance is your ability and willingness to accept the chance of losing some or all of your investment. It has two sides. “Ability” is how well your life would carry on if you made a loss. “Willingness” is how calm you can stay when you see that loss.
The two do not always match. Someone may be keen to take risk, but their income is uncertain and their family depends on them. Someone else may be financially secure, yet lose sleep over a 10% fall. It is usually safer to treat whichever of the two is lower as the limit.
Say Tania and Rafiq are both 30. Tania has a steady job, an emergency fund covering six months of costs, and no debt. Rafiq’s income goes up and down from month to month, and he also pays for his parents’ medical care. Same age, but Tania has far more ability to absorb a loss. Age is one factor, not the whole picture. The people are made up.
Why it matters to an investor
- To avoid selling at the worst time: people who take more risk than they can bear often panic-sell at low prices when markets fall, locking in the loss.
- To set your asset allocation: risk tolerance is one of the main foundations for how money is split between shares, bonds and deposits.
- To see the cost of too little risk: being overly cautious can mean your money fails to keep up with inflation over the long run.
- To avoid following others: what suits a friend or relative may not suit your situation.
What shapes your ability to take risk
- When you need the money: money needed within one or two years has no time to recover from a big fall. Money for 10–15 years away has more time.
- How steady your income is: a regular salary or remittance makes losses easier to absorb; irregular income makes it harder.
- Emergency fund and debt: without an emergency fund, or with heavy loan instalments, you may be forced to sell investments at a bad time.
- Who depends on you: the more family responsibility you carry, the bigger the impact of a loss.
Willingness: on paper and in real life
When markets are rising, almost everyone feels brave. The real test comes during a fall. For example, on 19 December 2010 the Dhaka Stock Exchange general index fell about 6.72% in a single day. Picturing what you would have done on such a day tells you a lot about your willingness.
Falls are not rare events either. The investor guide from the US securities regulator, the SEC, notes that large US company shares have historically lost money in about one year in every three on average. In other words, if you hold shares, bad years will come; the only question is when.
Worked example
- Say your total investment is Tk 5,00,000, with 60% (Tk 3,00,000) in shares and the other 40% (Tk 2,00,000) in deposits.
- In a bad year share prices fall 30%: the share portion drops by Tk 90,000.
- Your total goes from Tk 5,00,000 to Tk 4,10,000, an 18% fall on the whole.
Ask yourself: “a 30% fall” sounds abstract, but seeing “Tk 90,000 less”, would I stay calm, or would I sell? Your honest answer is a good measure of your risk tolerance. The numbers are only an example.
Common mistakes
- Judging your risk tolerance while markets are rising, when everyone feels brave.
- Setting risk by age alone, without looking at income, debt and responsibilities.
- Moving into risky investments without an emergency fund.
- Setting your risk tolerance once and never revisiting it. It changes with marriage, children, a job change or nearing retirement.
Of the risk you want to take and the risk you can afford to take, think of the lower one as your limit.