Basics of Investing – Risk Explained

Investing Basics – Learn the basics of risk, the difference between tolerance and ability, and the difference between human and financial capital.

How do you decide how much risk is right for you?

While this is a very personal decision, you need to ask yourself what your ability to take risk is and what your risk tolerance is. How would losing 20% of your portfolio make you feel? This goes with risk tolerance. How large and how dependent on your retirement savings are you right now? This goes with the ability to take risk. The higher your tolerance and ability, the more risk you can take, and vice versa. Now the difficulty is when they do not agree, when your tolerance is high and your ability is low, you need to think through your position and get your tolerance and ability on the same level. When in doubt, I recommend going with what your ability says you can withstand, and lean to the conservative side. The industry basics say, longer time horizon, more assets, less dependent on those assets you will be all point to a higher ability to take risk. The closer you are to retirement, with not enough savings, and a high need for those savings to cover your expenses, the less ability you have to take risk. Tolerance is a psychological factor, if you are naturally a risk taker and like to live dangerously, you will be more tolerant of risks in your portfolio, with the opposite being true if you usually play it safe and would be willing to forego an additional 2% gain if it meant you would avoid a 1% loss.

The CFA curriculum teaches you that there are two sources of capital every person has, human capital and financial capital. Your human capital is the money you will earn over your lifetime, and it has risk characteristics very similar to a bond (so consider it as part of the Fixed Income portion of your portfolio). Your financial capital is your assets minus your liabilities, or your net worth. When you are young, the value of your human capital (your future years of earning) is worth a lot more than your financial capital, and since your human capital is similar to a bond, you have the ability to invest your financial capital in riskier assets. This is one of the reasons why they say that when you are young and have a longer time horizon, you have more ability to take on risk. Another reason young people can take on more risk is that their retirement savings can survive multiple economic cycles, even if there is a recession, you style have time for your investments to bounce back.

As you near retirement, your human capital is declining, and hopefully your financial capital has been steadily increasing, so by the time you retire, you have replaced your human capital with financial capital well enough you do not have to change your lifestyle. But keep in mind that with your human capital (fixed income risk profile) declining, you need to make sure your balance of capital (human and financial) reflects the amount of risk you want to be undertaking (over time you want to take some of the risk out of your financial capital to counteract the decline in human capital).

The below chart shows how over time your mix of human capital and financial capital should be changing, the Y-Axis is the percent of your capital made up of Human or Financial Capital, and the X-Axis is the years in the workforce, with 50 years being when you would retire (human capital has declined to 0).


Stay tuned for more Modern Finance!

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4 Responses to Basics of Investing – Risk Explained

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