Zaks Investment Advisory Service

Risk Tolerance: acceptable levels of risk

Last time we discussed how risk affects stock market prices and what happens when, in the investor’s opinion, the investment climate changes and the situation becomes, for example, more risky. What we discussed may help our listeners understand the meaning of the financial phenomenon of “flight to quality,” i.e. the process of a mass sale of riskier financial instruments and the simultaneous purchase of instruments of “better quality,” i.e. less risky ones. An example of a “flight to quality” is a situation in which investors sell stocks in order to purchase bonds, or sell stocks in developing countries and invest in US or Western European markets. This, for example, happened in 1998 during the financial crises in Southeast Asia and Russia.

We also said that individual investors’ attitudes toward risk may be separated into numerous categories, from the very aggressive to the very conservative ones. Aggressive investors buy riskier securities (like growth stocks, or options and futures). Conservative investors purchase CDs and money market instruments.

How do you determine which category you belong to? Two factors play key roles. The first factor is subjective: it is how psychologically tolerant of risk you are (what is called “risk tolerance”). The second factor is more objective: it is based on which investments – more or less risky ones – you are better able to afford in your financial circumstances, based on your requirements and demands (what is called “risk capacity”).

There is no strictly scientific approach to the first question (like to most things of a psychological nature), but one may get a certain sense of it by analyzing your answers to certain specifically formulated questions. How risky a person you are is not related to your wealth, your current income or your requirements. Here are three examples:

As a result of a market correction, you investments lose 15 percent. What will you do: sell all of your investments so as not to worry about losing even more; do nothing and wait for them to pick back up; buy more investments of the same type, since at such prices, these investments look even more attractive to you.
When you hear the word “risk” in a financial context, which of the following phrases describes your sentiments about it the best: “a risky situation,” “an uncertain situation,” “a potential opportunity,” “an exciting situation.”
Compared to your friends, how do you tolerate stress associated with making important financial decisions: “poorly,” “average,” “easily.”

There are no right answers to these questions. But if you found that risk is dangerous, that you poorly tolerate stress, and that with a 15-percent market correction you would have probably sold your investments, then psychologically you are a conservative investor. If you find risk exciting, easily manage stress, and want to buy more shares following a market fall – you are an aggressive investor.

In contrast to subjective risk tolerance factors, your risk capacity depends on your specific circumstances and your plans. Here are several examples of these factors:

In how many years do you plan to start using the money you invested? The longer you decide to keep the money invested in the market, the more risk you are able to afford.
What part of your total assets would you like to invest in the market? The smaller the portion you invest, the riskier the portfolio you are able to afford.
What do you expect to happen to your future earnings: will they drop; remain about the same; grow slightly faster than inflation; grow quickly? If you think that you will be earning more in the future, then you can afford to risk more.

It would be good to discuss your answers to these questions with your investment advisor. The advisor may help you match your attitude toward risk with your requirements and demands. If they match – great, if not – then you will have to adjust your requirements so that they match market realities.

With this, we will have to draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.