Assess your risk tolerance before investing in stocks

Of late, too many investors rush to me with worry on their faces. As the markets turn volatile, despite the larger indices at high levels, the portfolios are underperforming. Only a few individual stocks have done well but have contributed huge to the index due to their skewed weightages. This has got many investors worried despite being part of the market cycles. The other reason is also due to the near-linear growth in the last calendar year, leading to complacency among the investing community.

Before investing, we generally mention about many fundamental jargon that defines the various parameters of the stock market. We talk about time horizons, volatility, risk tolerance, etc. but as we play in the market, somehow, we tend to either ignore or forget these critical aspects. It’s only when experiencing rapid and deep losses, would one recollect these principles.

As Warren Buffet famously put, “It’s only when the tide goes out that you learn who has been swimming naked.” This aptly suits these current set of investors who’ve now realised that they’ve swallowed much larger pie than they could chew. So, when the going was good all the caution is left to the wind and witnessing returns or success has led to dilute their shields and rationale.

During those periods, investors overestimate their risk tolerance. It’s human tendency to exaggerate the success while underplaying the failure. Risk tolerance as defined by Investopedia is “the degree of variability in investment returns that an investor is willing to withstand.” It means, the amount of swings in the returns or the investment values, an investor is willing to take defines their risk tolerance. When the volatility is low, investors could see their bets going their way and the increased exuberance could prone to committing mistakes.

One of the missteps is not properly assessing the risk of the individual or investing in avenues which are digressing from the risk profile. It’s easy to get swayed with statements like ‘invest when everyone is fearful’ and ‘buy when there’s blood on the streets’, etc. One has to understand that its easier said than done as during those times one may witness that their jobs are on line (of fire) and/or you are struggling to retain your clients. One would look for protection in those times of distress, trying to cover your leverage (or loan), preserving your capital or cash and enter into a survival mode. It’s difficult to ‘stay the course’ when things are adverse in the market, your confidence hits low and the outlook neither helps you.

Take for instance of mid-2013, when the rupee depreciated, policy paralysis, high inflation, twin deficits and bleak outlook, it was difficult to take positions in that market condition. The valuations were very low relative to their history, but many were worried to service their loans, retaining the liquidity and reducing the risk than exposing to markets. It’s when you actually lose money or on the verge of losing money would you realise the importance of defining and sticking to your risk tolerance. Remember investing is not about analysis and research but behaviour.

How to assess your risk tolerance? Some of these aspects could help. How much percentage are you willing to lose before you start to feel uncomfortable? How long would it take you to recover these losses? How are you going to compensate or what’re your alternate income sources? Do you’ve a survival fund and how long would it stay? How do you react to the market movements? Do you have a percentage target in terms of returns that you would call as success or gains? How many times have you lost money in stocks or otherwise? How did you cope up with? These quick reckoners could be a figment of some of the exhaustive questionnaires that are available.

My experience taught me that it’s very difficult to arrive at a tolerance level purely by answering the questions. Instead, a peek into their past would help come with some answers, not all. Investors experiences of losses, coping with those losses and emotions during those losses - important to document these. One could still discount the values/answers and safely arrive at a level which could be adjusted as the experience betters. It’s better to be cautious than sorry in investing.

By: K Naresh Kumar
(The author is a co-founder of “Wealocity”, a wealth management firm and could be reached at knk@wealocity.com)