your risk tolerance is confusing you?
If you have gone to a half decent ‘financial planner’ he starts by asking you ‘how much is your risk tolerance’? And you get to talk about how much is your risk tolerance. The funny part is YOU DO NOT KNOW how much is your risk tolerance.
Also for most people when a pretty young girl is asking, the 53 year old man does not want to look like a ‘coward’ so he ends up on a high scale – perhaps unwittingly!
You know how the whole drill goes right? the Ifa gives you a questionnaire and you are asked to fill it up. And the questions are not really easy to comprehend for the first time investor.
What I like to know about an investor is how much of fear, confidence, regret, over confidence, track record he has. Clubbing all of that under ‘fear’ or ‘risk tolerance’ is highly unscientific. My view, and I am different from others in my ‘profession’ of ‘being retired’ .
I am afraid that customers labeled as having a “high tolerance for risk” may actually be reflecting (over) overconfidence. They may be saying that they want to own direct equity because of a perception that they have a great ability to pick great stocks. Actually this overconfidence may come from being innumerate and not really a great skill at picking stocks! While investors who have no share market experience except watching television may be scared by the shrillness of the voices or the DAILY fluctuations. Actually it is FEAR of volatility and not lower risk tolerance. If I can hand hold them during a bad period (hey that is why I deserve my fees) and take them through a bad cycle followed by a good cycle, I am helping them realize that they ACTUALLY have a higher ‘risk’ tolerance.
Get the drift?
What worries me is that the BRAIN does not like fear. So after the event is over it removes it. So when we talk of ‘good old days’ it is just that the bad experiences are removed. So people talk of how 8 of them lived in a one bedroom AND they were happy and now with more money, they are not happy. FALSE. The lack of privacy, the fights, etc. have been cleverly eliminated by the brain. So if in 2017 if you ask him/her ‘how did you feel in 2008 – THEY ARE NOT LYING, but then they are FORGETTING that they were shit scared. The fear induced by the stock-market crash of the recession is fading, while the fear induced by the dot-com crash of 2000, 2008 or th RE crash of 2001 or even the crash of 1993 are long gone or CONVENIENTLY forgotten.
However, asking them ‘what returns are you expecting over next 12, 36 or 66 months’ is a lovely question. One CEO said 35% p.a. I said see your companies board minutes and the reports that YOU send to your board. He came back with a figure of 18.
I tell clients ‘if you have high expectations’ (which means they think they have HIGH risk appetitte) – you will be FAR MORE disappointed. So I temper expectations – telling them they will keep all the money, IMMATERIAL of expectations. Seriously these people have NO risk understanding. However at the end of a bear run, they are more REALISTIC to say 12%, where as during a bull run (sep 2017) they are likely to say ‘Midcap 30% and large cap 25%. Lol
To me the clients level of confidence or lack of confidence is far more important. Over time I am confident of managing clients fear and regret. Sure some people leave before that, and that THRILLS ME. Happy to deal with less numbers. Seriously very happy to lose people who are not on my page. Anyway not looking for people with low tolerance for patience and waiting game. Investors who are asked about their risk tolerance following high past returns are likely to be OVER OPTIMISTIC – actually they are over estimating by a mile! Investors who are asked following low past IMMEDIATE returns are likely to underestimate it, swayed by fear. Those who underestimate are just asked to stay away. Lol.
Most of us confuse between fear, risk, tolerance, standard deviation, regret, irrationality at different points in time and react DIFFERENTLY TOO.
Kumar
One easier way of thinking about risk tolerance could be to answer the question “if X amount of my liquid net worth is wiped out, I can still feel ok. What is the largest such X?”. Then that amount can be invested into high risk long-term instruments, with the assumption that there is a small but non-zero chance of it getting wiped out.
For a more aggressive amount, if you believe that the stock market crash may reduce your invested amount by half, then you can go further and invest 2X into stocks.
subra
clients have NO clue what is that amount
Madhusudhan
Dear Sir,
This post must be stickied to be read by everyone.
The problem lies with the notion of high risk equals high reward. The questionnaires and profiling ask such questions that it plays to the ego of the person to assume he knows everything. There must be alternative methodology rather than directly asking the investor questions to assign a risk category. It is very hard even for a seasoned investor to answer honestly and the lure of presumed high returns blurs the eyes when answering such questions.
kalyan
I don’t like the risk assessment questions used by most financial advisers – both offline and online. Full of subjective questions which can’t be answered. A question like are you fine with a return of 20% with a chance for -20% return is meaningless. Risk assessment should be objective.
I think risk should be measured based on present money, required money for the goal and duration etc. If you need some money in 6 months the risk tolerance is very low.If you need after 20 years tolerance is high. If you have very less money but need a lot of money for a goal you absolutely must reach your tolerance is high in the sense that you have no other way etc.
I know there is no solution here but assessing risk by asking subjective questions to a clueless person is definitely not a solution.
Hari
I would rather go by a goal specific risk profiling.