Risk tolerance is how emotionally comfortable a person is with taking financial risk. For example, how much a person is willing for their portfolio to diminish for a chance to make bigger returns. It is psychological and is best measured with a psychometric tool.
By knowing how comfortable a client is with investment ups and downs, advisors can make sure their clients don’t panic, or worse, blame the advisor when a risk is realised.
Risk Required (or Portfolio Risk)- Risk Required is the risk associated with the respective portfolio in order for the client to remain comfortable holding it for a longer period of time.
Risk Capacity- The level of Risk the client can afford to take.
Risk Tolerance- The level of Risk the client is "emotionally" comfortable with.
There usually is a mismatch between the above three. Usually a mismatch between Risk Capacity and Risk Tolerance leads to misunderstandings and investing in portfolios where Risk Required are either too high or too low than that of the client.
Understanding Portfolio Risk or Risk Required
Portfolio risk is more promptly described as portfolio volatility or major drawdowns of the portfolio. The same is a function of weighted average change in price of portfolio constituents. Each of our portfolios are
diversified across various industries and stocks (at least 14 stocks in each portfolio) making sure allocation to any individual stock is always less than 18%.
The same allows us to diversify unsystematic risk.
Regular rebalancing and churning ensures regular weeding out of under performers.
The above factors make our portfolios suitable for everyone as long as their exposure to the portfolio is limited to a percentage of their wealth.
Implying, If an extremely conservative risk averse investor with a low risk tolerance and low risk taking capacity was to invest 5% of his total wealth in our riskiest and most aggressive portfolio. Assuming the portfolio has heaviest weights of 18% in an individual stock which goes bust, the respective client would only lose 0.9% of his total wealth, in fact even if every stock in the portfolio was to go bust- the client would still lose only 5% of his total wealth.
However, we believe for the most aggressive risk seeking client the exposure to equities must never be more than (100- respective age) % ,viz.- each client must at all times over the ownership of all fixed assets have at least "his age" percentage in cash & cash equivalent assets. Example- someone who is 27 years old should have at least 27% of his total wealth, exclusive the ownership of all land/property & fixed assets in cash and cash equivalent, while someone aged 72 should similarly have at least 72% in cash & cash equivalent.
Understanding Risk Capacity
Risk Capacity is a function of
Age - Subdivided into three parts + Retirement, in the order of risk taking capacity being highest to lowest :
Acquiring Wealth- Recently employed; age range 20 to 36.
Saving Wealth - Stable Cash flow with additional responsibilities of a family; age range 36 to 54.
Distribution of Wealth- Stable cash flows with probable retirement insight with highly probable contingent cash expenses with additional responsibilities; age range 54 to retirement.
Retirement- Calculated cash outflows with highly probable contingent cash expense.
Percentage of total wealth invested and plan to invest- Lower the %age, higher the risk taking capacity.
Current Investments; Higher the diversification in current other investments, higher would be the risk taking capacity.
Percentage of Income, that goes into repayment of existing liabilities- Lower the percentage, higher the capacity.
Understanding Risk Tolerance or Willingness to take Risk
Percentage of average return and worst return you would be comfortable with before a certain expected best return.
However, in every situation where Risk Willingness > Risk Capacity the latter shall prevail. Implying, If a person who has Low Risk taking capacity shows willingness to take higher risk. Their Risk Category should reflect "Low Risk".
Considering lack of live performance of portfolios- we recommend a maximum exposure to each of them of upto 25% of total wealth.
Max Equity Exposure
Putting everything above together. While for most people our portfolios are suitable the proportion of optimal exposure they should maintain to respective portfolios depends from person to person given all factors explained above.