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Risk management isn’t a difficult concept to explain. We all do it every single day, whether it’s fastening your seat belt after you get into your car, or something as small as booking a table at your favourite restaurant.
When you get into your car, you do so with the intention of reaching a particular destination, in the same way that you expect to have a table ready when you get to the restaurant.
The seat belt is there to protect you in the unlikely event of an accident, in the same way that you also manage your risk by booking a table to avoid arriving at a fully booked restaurant without a reservation.
It is simply a strategy that you implement in order to manage particular risks.
Before you develop your investment strategy, you need to determine the amount of risk you can tolerate, irrespective of the type of investment you are considering.
Whether it’s a retirement annuity, a living annuity, pension or a small share portfolio, first determining your risk tolerance is the crucial step you need to take before moving forward.
The influence that certain factors may have on your risk tolerance, however, makes this a little more complicated than it sounds.
Let’s look at an example to illustrate this more clearly: a couple of newlyweds recently took a ski trip to Switzerland for their honeymoon.
On the first day of their honeymoon, the wife had an accident on the slopes and severely injured her knee.
Needless to say, their honeymoon turned sour almost immediately. Aside from the physical pain she had to endure, her emotions were negatively influenced by the injury she sustained.
For that reason, it is extremely important that you measure your risk tolerance by taking two aspects into consideration.
The first is emotional risk tolerance. Something you read in a newspaper, or even a slight injury or short-term illness may have such a negative effect on your emotions on a particular day that you may suddenly consider yourself to be a more conservative investor and you may even wrongfully go ahead and restructure your investments accordingly.
Proper financial analysis may indicate that you are able to take more risk in your investment portfolio, but due to your emotional discomfort you feel compelled to act more conservatively.
The second aspect is financial risk tolerance, which is directly linked to your financial well-being. You may have additional capital at your disposal that does not require any short- or long-term needs to be fulfilled, enabling you to apply a riskier investment strategy.
Of course, the opposite may also be true. Your calculated risk tolerance may be very high, but due to extremely limited retirement funds, for example, your financial risk tolerance may place you in a more conservative category.
In order to determine your risk tolerance, it is important that you consider the following main factors:
1. Required risk: This indicates the amount of risk that you need to take to meet your needs. Let’s suppose you have R1m to invest, from which you need to withdraw an annual income of R100 000, which cannot be reduced due to budget requirements.
This means that you need to take more risk than that offered by a conservative investment such as money market (around 7% interest per year).
It also places emphasis on the importance of having an effective savings plan. The earlier you start to save, the fewer risks you will need to take later on in your life.
2. Risk capacity: This indicates your ability to stomach a loss. If you cannot afford to finance short-term losses in your portfolio, it would be wise to avoid high-risk investments altogether.
3. Risk preference: This indicates how much risk you want to take. It doesn’t depend on your financial well-being, and is more emotionally driven.
It may indicate your ability to take higher risks simply because you feel comfortable in doing so.
There are many online tools available that can help you to determine your risk tolerance. If you’re unsure, however, you can always consult a professional to assist you before you enter the investment world.
Schalk Louw is a portfolio manager at PSG Wealth.
This article originally appeared in the 7 September edition of finweek. Buy and download the magazine here.
