The many facets of risk

Understanding risk aversion, loss aversion and risk capacity will help you think clearly about particular investments.

Michael Keaveney 3 April, 2017 | 5:00PM

 

 

Determining if a particular investment is appropriate for you is an important consideration, whether you’re making investment decisions yourself or receiving advice from a professional. You should be thinking about the investment in the context of your specific goals, your time horizon and your circumstances. Part of this thinking should also address the various facets of risk.

We’ll start with your risk aversion: That’s a personal assessment and a behavioural measure of your willingness to take on a degree of uncertainty in the outcome of your investments. People differ in how much risk they are willing to take on, and your own willingness could be influenced by your natural instincts and your previous investment experience.

A similar sounding concept, but a different risk measure, is your loss aversion. Here, you need to be thinking about how you’d react when your investment actually goes down in value. Behavioural researchers know that people dislike losses more than they like equivalent gains. Your actions in the event of a downturn in your investment--would you hold onto the investment, or sell and move on, or perhaps even buy more?--are important to consider, and also likely influenced by your unique instincts and experience.

Lastly, there’s risk capacity. That’s your ability to take on investment risk, as opposed to your willingness. Here, you will be considering that, if your investment is down in value, are there mitigating factors- other sources of wealth like pensions, steady employment, and other investments- that insulate you, and successfully meeting your goals, from potentially negative outcomes from the investment you’re considering.

Determining your risk profile won’t be a one-and-done proposition. You’ll need to revisit it on occasion. A review could be triggered by a change in your major objectives or goals or a change in life circumstances. The passage of a significant amount of time is also a trigger. For example, if you are accumulating assets for a retirement goal, every year you are getting closer to your retirement date, and your time horizon for assessing acceptable risk could be changing.

Finally, don’t forget to periodically rebalance your investment portfolio to always be compatible with the thinking you’ve done about the risks and potential losses you’re willing and able to take on.

About Author

Michael Keaveney

Michael Keaveney  Michael Keaveney, CFA, is Director, Investment Management at Morningstar Associates, Inc.