I have been lately thinking a lot about taking risk. It is such a commonly used word in our everyday lives. But is it really understood? What makes some people more risk takers compared to others?
What is risk?
Risk is the uncertainty that we face when we venture into the ‘unknown’. If I could express it in the following dilemma:
“Warning: Danger Ahead. We have lost our way. Will this path lead us out of the jungle? Should we take the risk?”
- What is the probability that you this new product would succeed?
- What is the chance that you will go on to live 100 years?
- What is the chance that you would succeed in your startup?
Different ways of referring to the same thing… the unknown.
Risk is the uncertainty that accompanies when we do something that we don’t know about or don’t know enough about.
Another way to understand risk is, “it is the chance that the actual outcome of an event or action will be different than the expected outcome“.
While we tend to avoid taking risk, the fact is that risks, taken well, can pay off handsomely.
Mark Zuckerberg of Facebook said, “the biggest risk is not taking any risk at all. In that sense, risk is about getting out of the comfort zone.
Risk in Investing
There is an overblown fear about risks in investments. And that is because of the way we perceive investing and the lack of understanding about our risk taking capability. You may only be ready to take some risk with your investments but you go ahead and put your money into some Z category penny stock and lose it all.
Frankly, that’s stupidity. The fact is you can do better by assessing risks properly and taking informed decisions with your investments.
Investing in any market-linked security has risks associated with it. There are several factors that you don’t know about or can’t predict with certainty and that’s where the risk lies. Let’s see some examples.
Will this equity mutual fund give me a 12% return or a 20% return?
Will I get my investment back, if I invest in this stock?
In contrast, a Bank Fixed Deposit which has a certain 8% per annum rate of interest is considered risk-free. Similarly, the Government of India Bond with a 6% interest rate is a safe or non-risky investment.
Market linked investments are influenced by several factors, which add to the uncertainty of their delivering returns. In some cases, even the return of capital or original investment could become doubtful. Having said that, a well selected group of market linked investments, such as equity, can multiply your wealth over a period of time.
The risk in investments is spread across a spectrum, a range, low to high. We call some investments less risky as compared to others based on the uncertainty attached with them. In other words, what is the probability of they delivering on the expected return?
The key lies in making the effort to understand your own risk taking capacity and to make your investments accordingly. I will extend this thought further and ask you the big question.
How much risk can you really take?
Basically, how ready are you for facing this uncertainty with your investments?
I am not sure if it is really possible to place a perfect number or a score or a percentage to your risk taking capacity.
However, some questions can help. Based on my interactions with several individual investors over time, I have created a set of questions, which you can also use to assess your risk taking capacity.
This is not a foolproof questionnaire. As I said, the idea is to help you come closer to understanding your own risk taking capacity. This can then enable you to make efficient investment decisions that help you achieve your financial goals.
So, let’s go.
9 questions to help you assess how much risk can you take
Mark your answers as you go through the questions.
- What is your current age?
- (a) Less than 30 years
- (b) 30 to 45 years
- (c) Over 45 years
- Which one are you?
- (a) Salaried – Fixed income secured job
- (b) Professional – Doctor, Chartered Accountant, Company Secretary
- (c) Freelancer – No steady income
- How many financial dependents do you have?
- (a) 0 to 1
- (b) Upto 3
- (c) More than 3
- What type of holiday are you more likely to take?
- (a) Adventure holiday – Scuba diving, Bungee jumping, Mountain trekking
- (b) Go to a resort and just relax
- How do you learn about investing?
- (a) Through reading books, websites / blogs
- (b) Through friends and colleagues
- (c) My advisor does it for me
- Which one of the following explains the rule of 72?
- (a) A thumb rule to understand the power of compounding
- (b) An investor should have 72 investments to achieve proper diversification.
- (c) It will take 72 months at least for any stock to deliver returns
- Which one of the following are you more likely to invest Rs. 100 in?
- (a) Where you can potentially get Rs. 130 but you can also lose Rs. 50
- (b) Where you are assured to receive Rs. 110 without any risk of loss
- (c) Rs. 50 in each of the above
- Which one of the following is true about investing in stocks?
- (a) Time in the market – you have to remain invested for a long period of time
- (b) Timing the market – you have to enter and exit at the right points to make money through stocks
- What is the current level of your investments?
- (a) Enough to take care of my financial goals
- (b) Somewhat enough to take care of my financial goals
- (c) Not at all enough to take care of my financial goals
How should you understand the result?
The answers would tell you your risk taking capacity. If you have more of A as your answers, then you have a high risk taking capacity; if there are more of B or C, you have a lower risk taking capacity.
Please Note: These are not the only factors to assess your risk taking capacity. There can be many more.
You risk taking capacity could be different with different financial goals that you have. If you have a financial goal a few months or a couple of years away, you will not take risk with it. It is best to consult your investment advisor to understand what risk is best suited for your investments.
Between you and me:
I believe you will share with me your risk taking capacity in the comments below or in reply to this email.
Reference: Here is all that Wikipedia has to say about risk.