How much risk is right for you

Quiz: What is your risk appetite?

Here’s a quick interactive quiz.

This quiz is featured in Burton Malkiel’s – A random walk down wall street and is designed by personal finance expert William E. Donoghue and the editors of Donoghue’s Money Letter to help investors determine the amount of risk you are likely to feel comfortable taking. Needless to say, no simple questionnaire will give you a completely reliable index on your tolerance for risk, but it will make you think.

Fill in your email id, name to sign up for the TCI newsletter and click the ‘Start Quiz‘ button.


Risk in real life

Global statistics on travel safety
[table “” not found /]

What this means: Planes (much) safer than Buses & Trains (much much much) safer than Cars.

Simply put, based on historical data, the risk associated with one mode of transport is considerably lower than other modes of transport. Hence based on calculation of risk, which is the probability of loss, a rational person should, in general, choose to fly over driving. Note that this doesn’t mean every time we get behind the wheel of a car, we’re risking our lives, it’s just that there is a “less risky” mode of transport available.

Risk in finance

Over in the world of finance, since there is no life and death (except the self-inflicted kind), risk has been defined slightly differently, as the volatility in value of an asset or asset class.

Volatility: A statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by using the standard deviation or variance between returns from that same security or market index. Commonly, the higher the volatility, the riskier the security.

This means, if you’re risk averse, pick the instrument with the least volatility. HDFC today offers fixed deposits with a (pre-tax) rate of 8.25% annual interest locked in for 5 years. This is irrespective of whether inflation averages 4% or 9% over this period. Compared to that, a share of the Nifty index offers no such promise but historical data suggests an annual post-tax return of upwards of 10% compounded. Something’s not quite right, isn’t it?

Volatility = Risk of a security has been the doctrine in finance courses for a long time. This has lead to simplistic rules about asset allocation like “Your allocation to equities should be 100 minus your age”, the rationale being a 50 year old should have not more than 50% of her assets in equities. This makes less and less sense since a 50 year old has fewer years of an inflation-beating salary to rely on for retirement and with potentially another 30 – 40 years to live, needs the long-term growth offered by equities.

Volatility ≠ Risk

If risk while travelling from point A to B, is the probability that a person will die due to some kind of accident, then risk in finance should mean the probability that a person is unable to maintain their chosen standard of living.

Classifying periodic drops (or jumps) in the notional value of a portfolio as risk seems equivalent to focusing on the variability in travel times across modes of transport and classifying the one with the highest volatility as the riskiest

Sure enough, the most telling endorsement of this idea comes from the Berkshire 2014 letter to shareholders:

“Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.”

Risk is in the eye of the beholder

Another reason why traditional methods of defining risk and suitability for investors make little sense is because people with similar financial characteristics react very differently to identical market occurrences. Chart shows Nifty between beginning of September and end of October 2008, when it slid down 42% in the wake of the global credit crisis.

The Calm Investor

If you were invested in this period, what did you do? Get disillusioned by equities and washed your hands of all stocks by selling everything? Or did you hold on and hope that it would go back up? Or did you get excited about how cheap stocks were and buy?

Your response to market fluctuations determines your risk appetite. Choice of assets should therefore be driven by your own temperament and ability to “sleep at night


 Interpreting your risk score

Based on the Donoghue money letter, the scores are classified into three buckets with these explanations:
[table “” not found /]

Investors would be well-served to use this insight to compensate for likely self-defeating behaviour and to not get distracted from the aim of investing for the long-term.

If you scored below 21

  • Return of capital means more to you than Return on capital. The idea of the slightest speculative element in investments is likely to keep you up at night, irrespective of how they do, potentially leading to self-defeating actions (like selling at market bottoms)
  • You’re best suited to work with a financial adviser who can talk you through a long-term plan and how equity investment fits into it
  • The mandate for the adviser should ideally be to allocate money to funds investing in large-cap blue chip funds of pedigree only with the remainder in liquid funds. Suggest taking a largely hands-off approach with semi-annual interactions to review performance and discuss rebalancing if markets have risen rapidly
  • Investing mistake you’re susceptible to: Stay away from equities citing their riskiness and stick with recurring deposits and bonds over the long-term

If you scored between 21 and 35

  • You’re ready and willing to invest for wealth-building and at the same time understand that stock prices rarely move in a straight line
  • Best suited to do some of your research and decide on an overall asset allocation plan that should ideally consist of index funds, large cap funds making up the bulk of your allocation, combined with a smaller percentage of your personally chosen stocks, all meeting stringent criteria on sales, consistency and quality earnings
  • You would be well-served by leaving the funds on auto-pilot, with monthly SIPs that are adjusted upwards each year and to revisit your stock picks not more often than once a year
  • Investing mistake you’re susceptible to: Letting Mr. Market dictate your actions, by buying when all the tickers show up arrows and backing away when markets fall

If you scored above 35

  • Falling at the other end of the spectrum from the overly conservative investor, speculative investments are likely to appeal to you, but the challenge will be to steer clear of leverage in order to boost returns that could well undo years of good work
  • In terms of asset allocation, the suggestion would be similar to that for the 21 to 35 scorers, with the difference in the composition of the funds chosen. Here, you could expand your consideration set to funds investing in mid and small caps given their tendency to outperform large caps given the right conditions
  • If it appeals to you, earmark a small part of your portfolio for more “active” management but set limits on both maximum allocation and to number of times in a year you review and “take action”. Leverage of any kind should be an absolute no-no given it’s asymmetric payoffs
  • Investing mistake you’re susceptible to: Mistaking the stock market for a casino and trying one-too-many “strategies”

The simplicity of the quiz is meant to identify broad tendencies in your investing behaviour and should be used only as an indicator of the kind of mistakes you’re likely to make and be able to take steps to counter them. In the end, the only certain way to learn about investing is to read as much as you can and to start with small steps to understand your own self, strengths and weaknesses better.

Further Reading:

Continuing on TCI…

Diagnosing Mr. Market – The Calm Investor

SIP, don’t guzzle investments – TCI

Other…

An introduction to risk and return – Investopedia

Models of risk and return – Aswath Damodaran

Know your investing risks – Monevator

The nature of risk in value investing – Value Stock Guide

Take a risk, the odds are better than you think – Forbes

3 thoughts on “How much risk is right for you

What do you think?