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Confused about your risk taking capacity? Answer is in how much loss you can bear

Author: Kumar Shankar Roy/Wednesday, April 18, 2018/Categories: Financial Planning

Confused about your risk taking capacity? Answer is in how much loss you can bear

Talking about disasters is not considered good in our society. Rather, we are taught to focus on the positives. This is why new and old investors are often perplexed when asked about their risk taking capacity. Those with large egos, like to think they are high risk takers. Those with a conservative mindset, never take risk. But the truth, as they always say, is in the middle.

Our risk taking ability is a measure of our comfort level with investments. However, the popular way of talking about risk is generally linked and measured with reward being the proverbial carrot. So, we are taught that taking high risk means getting high rewards.

Unfortunately, this kind of risk-reward relationship explanation is built on half-truths. Risk doesn't only mean reward; it also means accepting the probability of some loss. That is why your capacity to bear losses is a far better indicator of your risk-taking capacity. Let us find out why.

What if it doesn't

Everything is generally assumed to work smoothly. However, life is not short on surprises. When something doesn't happen in the way it was planned, it has its own share of effects. We expect stock markets to go up. We anticipate salary hikes to continue. We expect bank deposits to be hundred percent safe. We think gold will always become increasingly valuable. What if all or any of this doesn't happen in the way you have envisioned? That's called risk. In the wild chase for returns, never forget risk.

The risk of not meeting your expectation is quite frightening. For instance, the danger of not having enough for retirement is scary especially if you realise it when you are already 65. Having inadequate money for son/daughter's higher education or marriage is a terrible truth if you calculate it just a few weeks ahead of it.

Risk as loss 

Our ability to bear and cope with losses is what tells us how risk-taking or risk-averse we truly are. It's as simple as that.

To assess your capacity to bear losses, ask yourself two simple questions.

1. How much loss can I tolerate? The answer should be specific and a number in percent.

2. How long can I accept the loss? The answer should be a number in days, weeks, months or years.

Both answers are required. For instance, if you can tolerate 20 per cent loss it is important to know how long will you wait before panicking. If you can bear a 20 per cent loss to your initial investment for 1 year, it tells you that the moment the year is up --- you will start becoming jittery.

Understanding your risk bearing capacity will help you choose investments easily. Whenever you are sold an investment, tell the seller about your loss taking capacity. 

It is also true that in the world of investments, risk is more or less a fact of life unless we are talking about government debt or guaranteed fixed income.

Stock market contains the risk of capital erosion in the short, and medium term. However, the risk of capital erosion subsides if the investment spends more time in the market. There are no guarantees.

Fixed income contains a small amount of risk in terms of capital erosion. In most cases, fixed income has some sort of a guarantee and that is why the returns are also capped.

Gold, history has showed, also contains a little bit of capital erosion risk if you buy it at an elevated price. There is no guarantee of returns.

Real estate, especially since it is held for long periods of time, limits capital erosion risk to some extent. Here too there is no guarantee of returns, but seldom do investors sell realty at a loss unless it's a fire-sale.

Crypto currencies like Bitcoin have huge amounts of capital erosion risk even in the short term. Plus, investors need to be comfortable with wild swings on a daily basis.

Happy Investing!

The author is a personal finance journalist with over 13 years of experience

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