Risk - When Do You Chicken Out?

Evaluating how much risk you can take is quite difficult. This is a personal decision primarily because there is no objective criterion. That was not the case when you were defining your goals and time horizon.

What is risk tolerance? Very simply, it is the limit up to which a person is able or willing to bear declines in the value of his/her investments, as they wait for the market to look up. Some investors stay focussed on their long-term investing goals and don't get too worked up by market fluctuations, while others start fretting at the slightest hint of a decline.

How strong or weak a person is emotionally affects to a large extent how s/he decides to allocate his/her investment assets. Besides, factors like job security, level of income, family wealth or other circumstances also have an impact on the person's ability to bear risk.

Most of the high-risk investments are related to equities. So keep in mind the following:

· In most bear markets, stocks typically lose 25% of their peak value, though they could lose even as much as 50%. Selected stocks could even lose up to 100%.

· Over the past four decades, bear markets in the US have occurred on average, once every five years. In India, over the last fifteen years, we have seen four bear markets.

· In 2000, the BSE Sensex lost more than 50% from its peak, while most IT stocks have lost between 60-95%.

To understand your own risk tolerance, you could ask yourself the following questions:

1. If the stock market loses 25% or more, would you still buy more equity?

2. Have you slept soundly through the recent fall in Nasdaq, and IT stocks on the BSE, although you have a considerable investment in tech stocks?

If you answered "Yes" to both questions, then you don't seem to mind taking risks with your money. If the answers are "No", then it would be better for you to choose a more cautious asset mix where the investment in equity is less. The flip side of this is that there is the possibility of inflation eating away a large chunk of your returns.

Although a lot of the discussion on "risk" focuses on equity, you must always remember that other instruments also involve some amount of risk. Even some AAA rated company bonds have failed to live up to their promise and have defaulted on principal and interest payments. Bank accounts, which are considered to be "super-safe" choices, like can collapse. Bank of Karad is one such example.

It is important to mention at this point that with time, your circumstances may change, and with it your tolerance for risk, or even your need for financial security may change. For example, you may have the good fortune of inheriting a large some of money. This windfall might enable you to look at risk in a different light. Also, when you are single, your goals and responsibilities are different than when you are a parent. You will be less willing to take risks when you have dependents. This affects how you allocate assets in various stages of your life may vary according to your needs and your level of risk tolerance.

Shall we move to the next stage of the asset allocation process then?

Next.......

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