Monday, March 7, 2016
Knowing my willingness and ability to take risk
In finance world, willingness and ability to take risk belong to 2 different concepts. Willingness to take risk refers to one’s character, education, investment experience, culture and even religion.
For instance, many colleagues around me are high income earners. However, they only invest in time deposits as they are either conservative, have poor experience in investment or simply cannot invest due to religious constrains. They are unwilling to take risk for mainly emotional reasons.
On the other hand, ability to take risk refers to quantifiable criteria like level of wealth, investment horizon, liquidity preferences and investment objectives. A investor with $5M in his account will most likely not hesitate to invest $250k into a high yield bond. His ability to take risk comes from his ability to lose (more) compared to the investor with a much lower level of wealth.
Similarly with a lower liquidity preference and longer time horizon; investors are recognised as having higher ability to take risk and hence often advised to invest in riskier asset classes to enhance returns.
In a bullish market, investors’ ability to take risk increase dramatically as their wealth increase in tandem with the rising market; the euphoria sets in, reinforcing their positive experience and thus raising their willingness to take higher risk. Unfortunately, all bull markets will eventually lead to high levels of speculation towards the end cycle of bull markets. For instance, the China market rallied more than 50% within 1 year of mutual fund investment. I took profit then, realising close to a 50% gain as seen below due to the unsustainable yearly returns.
Vice versa, a falling market will always lead to lower stock trading volume as investors become poorer and reduce their ability and willingness (due to poor experience) to buy risk assets.
However, the above definitions are purely academic. Ability and willingness to take risk, really, is subjective and varies for an investor sometimes even at different times of a day!
Nobody truly knows their willingness and ability to take risk until going through at least one bull and bear market cycle. Suitability tests on investments are just a rough gauge at best to determine one’s risk profile.
This is the same concept for inflation figures. Our official figure for inflation is between 2%-4% over the past few years. However, the inflation figure is only true for us if we consume products in the exact same composition of the basket of goods used to calculate inflation.
In reality, every one’s inflation figure is subjective; by the same token, every individual’s risk profile is unique and cannot be measured using standard questionnaires.
The current bear market is into its 11th month. Till date I have reinvested all the dividends (for funds) and traded bank bonds (which have rallied due to risk aversion) to higher yielding bonds. At times, I do have regrets of not selling EVERYTHING at the peak (who doesn't!) and purchasing now instead. However, every bear market I experience will only reinforce my mindset to stomach risk, enhancing my willingness to take risk. It also serves as a test of my current portfolio's Value at Risk and its ability to resist market shocks like now. In fact I have a better idea of how my portfolio will behave during stressful market conditions.
Thus, in order to maximise your return on investment given your risk profile, stay invested in bear markets and lime me, you will know yourself better on your ability and willingness to take risk!