Monday, April 5, 2010

Difference between Risk Tolerance and Risk Taking Capacity

These two terms Risk Tolerance and Risk Taking Capacity are commonly encountered in any article that talks about investment or financial planning. Many people usually confuse these two terms and hence I thought it would be a nice idea to clarify on it.

Before we go on we need to know "What is RISK?"

Risk on an investment instrument is the chance that your investment would go down in value, i.e., you lose money.

Ex: You buy 1000 shares of ABC Ltd. today @ Rs. 100/- per share by investing Rs. 1 lac and after 10 days due to a bad news about the company the price per share goes down to Rs. 10/- per share (Ex: Satyam Computers SCAM) Your total net investment's worth is only Rs. 10,000/-

Such an unexpected event is termed as a Risk on the investment.

What is Risk Taking Capacity:

Risk Taking Capacity is termed as the capacity an individual investor has in terms of taking risk with his investments. He/She has a higher chance of managing his finances even in such an unfortunate event. A young man in his mid 20's and earning well can manage such a stock price tumble but his elder brother in his early 30's with a wife and a child cannot handle this because he has a family depending on him.

This is called the Risk Taking Capacity.

You might already know that there are many classes of investments with equities and debt being the two most common ones. As a rule of the thumb the % exposure to debt instruments should be your current age and % exposure to equities should be 100 - your current age.

Ex:

Ajay is 25 years old. So his asset allocation should be

Equities - 75%
Debt - 25%

Ajay's elder brother Vijay is 35 years old. So his asset allocation should be

Equities - 65%
Debt - 35%

As you can see above, as your age goes up your exposure to equities comes down and the exposure to debt goes up.

Risk Taking Capacity is the amount of RISK you SHOULD take on your investments considering various factors. These various factors include:

1. Your Age
2. No. of Dependents (Old Parents, Wife, Children)
3. Security of your current job

Based on the various parameters that suit you, your allocation towards debt must go up and equities must come down.

Risk Tolerance:

This is another term that is commonly used. This simply refers to the amount of losses you can tolerate. For Ex: Ajay being a youngster is very enthusiastic and the moment he makes some losses in the stock market, he spends sleepless nights, withdraws his investments even if it means suffering losses etc whereas his elder brother Vijay has already lived through those stages and hence doesn't sweat much in case of such mishaps and tries to make the best of the given situation.

Here Ajay's Risk Tolerance is LOW whereas Vijay's Tolerance is HIGH

It is simply a matter of the mindset and its capability to handle losses.

You and me need not be exactly in either Ajay or Vijay's situation but we could be a combination of both.

Make sure you check your Risk Taking Capacity and Risk Tolerance before deciding on your investment instrument.

Happy Investing!!!!!

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