You may have the tolerance for Risk, but not the capacity

Jul 06, 2023

Should you go online, you will not find a shortage of risk tolerance questionnaires. The questions range from mundane to entertaining, giving you options to select for each answer.

  • How would your best friend describe you as a risk taker?
  • You have just finished saving for a "once-in-a-lifetime" vacation. Three weeks before you plan to leave, you lose your job. You would…
  • I understand the value of my portfolio will fluctuate over time. However, the maximum loss in any 1-year period I am prepared to accept is…
  • In March 2020, the stock market plummeted. If your portfolio lost 45%, you would….
  • Suppose a relative left you an inheritance of Rs 1 crore, stipulating in the Will that you invest ALL the money in ONE of the following choices. Which one would you select?

Evidently, individuals are asked to imagine losses of certain magnitudes and see if that's something they have a comfort level with. These questionnaires give some sort of indication of an investor's ability to withstand short-term losses.

So usually when you hear about risk tolerance, it's framed in terms of your psychic ability to handle a certain level of loss. While it does have a role to play, the prime issue with this approach is that it confuses someone’s capacity to take risk with their actual desire to do so.

On the other hand, risk capacity is a measure of how much risk your finances can realistically absorb.

Take a 26-year-old living with her parents. No dependents. No debt. The big ticket expenses are covered by her family. But since the swings in the equity market scare her, her savings are channelized into bank fixed deposits, the Public Provident Fund (PPF), and the Employees Provident Fund (EPF).

This young lady has a low risk tolerance despite having a high risk capacity.

The attitude towards taking risk and making mistakes, personality, comfort level with upheavals, and mental makeup will determine the tolerance level. The income, investments, number of dependents, expenses, and time horizon for various goals will determine the capacity for risk.

Risk Tolerance: Don't give too much attention to it.

Too much focus here means that you're essentially letting your gut drive part of your decision making. You may end up going overboard on equity, or drastically underinvested.

People overestimate their tolerance levels when the market is relatively good. And then they crawl under the covers when it gets choppy, and, worst of all, sell in panic.

Conversely, you may have a high risk tolerance but not the capacity.

Risk Capacity: This is extremely important.

This is important concept for people who are putting together their portfolios because it focuses on one’s actual ability to withstand losses in their portfolio.

Risk capacity is also a function of the time horizon. If you have a very short time horizon, your capacity for risk is obviously different than if you were talking decades though your tolerance may be high. Which means that if you have five years to retirement, you cannot withstand losses of 35% in a portfolio that is packed with stocks. You wouldn't be able to make that back before you need to start drawing upon your portfolio.

This is important.

Neither are static. Both keep fluctuating as circumstances change and mindsets get impacted by experiences.

Also, in reality, people behave differently from what they express in a logical questionnaire. When the stock market plunged in 2008 and 2011 and 2020, investors realised that their tolerance was not as high as they perceived it to be. But when the market steadily climbed upwards, they were once again willing to take risks. It’s interesting to see how brave investors get in a bull market.

Tolerance and capacity are two very important concepts in the multifaceted topic of risk. Neither can be ignored. Having said that, let your capacity for risk lead the way, as it will lead to portfolio that stacks the deck in your favour.

More on Behavioural Finance

Larissa Fernand is an Investment Specialist and Senior Editor at Morningstar India. You can follow her on Twitter

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