What Investors Get Wrong About Risk - Articles & Commentaries

ADDED:

05 September 2019

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One of the first steps to investing successfully is to determine your risk profile at the onset before building a portfolio Investors often do this by answering a series of questionnaire that touches on their attitudes toward risk and also net assets.

The answers would then ultimately serve as a guide to asset allocation and set the risk-return parameters in a portfolio. Hence, it is a crucial step that investors need to get right at the beginning to avoid a risk mismatch in a portfolio. But the concept of risk can be tricky terrain for investors to manoeuvre especially when psychological biases and market volatility comes into play.

Among the most common misconception that investors have is the level of risk that they are prepared to accept and actually able to take.

Understanding your Risk Profile

According to Investopedia, a risk profile is an evaluation of an individual's willingness and ability to take risks. There are two parts to the equation here, i.e. willingness and ability to take risks. Investors often get confused between the two.

The conundrum that investors face lies when one's risk tolerance and risk capacity differ from each other. Taking too much risk than what one's risk capacity allows could compromise financial security and lead to undue risk in a portfolio which is more than what the investor's personal standing can handle.

On the flipside, taking too little risk when the investor's capacity actually allows for more aggressive exposure may lead to a shortfall in reaching their financial goals. This means that the portfolio would generate lower returns and the investor may have to settle for something for lower than originally intended or even delay their life goals/plans.

Reconciling with Risk

Whether one has an aggressive or conservative risk profile, all investors have an aversion to loss and hate losing money. However, risk should also be defined in terms of opportunity cost by not participating in upside gain due to not having sufficient exposure. Put simply, the risk of taking too little risk.

Understanding one's risk profile may require some form of discovery or trial-and-error. The best yardstick for investors to use is to ask themselves if they can sleep at night knowing how much wealth they have invested and confidence in their allocation.

Gradually though, investors can learn to manage risk through diversification across asset classes, sectors and regions as well as hedging (e.g. currencies) to have the best chances of success to reach their financial goals.

Sometimes, the biggest risk is not taking one.

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