A. WHAT IS RISK?
· Risk simply refers to the possibility that what we expect may not happen.
· To manage risk is to ask what can go wrong and what we would do if it does.
· The first problem is that we fail to consider its outcome realistically.
· The second problem is the faulty reaction to an unexpected risky event, leading to further risky events.
B. FACTORS AFFECTING YOUR ABILITY TO TAKE RISK
1. Your age
· The lower the age, the higher the capacity to stomach risk, because you can afford to wait till the investment bounces back in case of a downturn.
· As a thumb rule, your level of equity exposure should be 100 minus your age.
2. Variability of your income
· An unstable income impacts your risk profile as you need a bigger emergency fund.
· With a regular income, you can afford to opt for instruments that are risky in the short term but rewarding in the long term.
3. Your liabilities
· If you have financial commitments, you cannot take risks with your investments.
· Ideally, a person’s debt repayment should not be more than 50% of his income.
· On the other hand, if you are debt-free, you can invest in riskier assets.
4. Your dependents
· If you are the sole earner for an extended family, you will have a lower risk appetite.
· You also need to buy more insurance and maintain a larger emergency fund.
5. Your past investments
· They allow you to allocate a larger portion of your incremental investments to high-risk assets.
· However, if you have not saved enough, you cannot afford to take risks.
6. Industry you work in
· The industry in which you work determines the stability of your income too.
· This, in turn, affects the amount of risk you can take in your investment.
C. MANAGING RISK
1. What are the ways to manage risk?
· Ensure that you hold a combination of assets, so that impact of fall in value of one asset does not dent the entire wealth.
· Never believe that risk-free investments exist, as risks exist in all of them.
· Stop trying to predict the future asset prices as they may fall or rise.
· Stop searching for acquiring the next best thing, and focus on managing your own portfolio.
· Always have a well-articulated corrective action in place for managing a risky event.
· Fix a downside risk tolerance level as there is no merit in holding on to a losing position.
· Utilise the capital released from such positions to work elsewhere to recoup the losses.
2. Can overconfidence be a risk?
· Having confidence is a pragmatic assessment of one’s ability.
· However, overconfidence or over-optimism reflects abnormal faith in your own abilities.
· It is an unrealistic, subjective opinion about one’s prowess, ignoring the obvious questions.
· Over-optimism also leads to undue risks or ignoring the merits of a sound proposition.
3. Can it be overcome?
· You can temper your overconfidence in investing by having an investment plan.
· Remember that past performance doesn’t mean you will always land a winner.
· The decision should be based on rationale, not intuition or optimism.
· Exercise due diligence and have sufficient information to base your decision on.
· Choose your investment tools based on your financial goals and risk appetite.
· Control your over-optimism by slashing 25-30% off from your growth estimates.
· A disciplined, methodical approach to investing is the best way to beat overconfidence.