Willingness and Capacity to Take Risk

Distinguish between the willingness and the ability (capacity) to take risk in analyzing an investor’s financial risk tolerance. The first two factors in investment decisions are expected return and risk. However, we don’t know how much risk averse ourselves are yet. Since all investment decisions will be dependent on risk, it is important to learn the concepts and test risk tolerance (willingness to bear risk).
Read the following relevant concepts and take the risk tolerance test (that shows your willingness to bear risk).
Share your score of risk tolerance and discuss why you have that amount of risk tolerance.. In addition, if your capacity to bear risk is higher (or will be higher) than your willingness to bear risk, then are you going to consider more allocation into risky assets? Why? Or Why not?

 
< Concepts- willingness and capacity to take risk >

An investor’s ability to bear risk depends on financial circumstances. Longer investment horizons (20 years rather than 2 years), greater assets versus liabilities (more wealth), more insurance against unexpected occurrences, and a secure job all suggest a greater ability to bear investment risk in terms of uncertainty about periodic investment performance.
An investor’s willingness to bear risk is based primarily on the investor’s attitudes and beliefs about investments (various asset types). The assessment of an investor’s attitude about risk is quite subjective and is sometimes done with a short questionnaire that attempts to categorize the investor’s risk aversion or risk tolerance. Complete the Risk Tolerance Questionnaire attached below.
When the adviser’s assessments of an investor’s ability and willingness to take investment risk are compatible, there is no real problem selecting an appropriate level of investment risk. If the investor’s willingness to take on investment risk is high but the investor’s ability to take on risk is low, the low ability to take on investment risk will prevail in the adviser’s assessment.
In situations where ability is high but willingness is low, the adviser may attempt to educate the investor about investment risk and correct any misconceptions that may be contributing to the investor’s low stated willingness to take on investment risk. However, the adviser’s job is not to change the investor’s personality characteristics that contribute to a low willingness to take on investment risk.
The approach will most likely be to conform to the lower of the investor’s ability or willingness to bear risk, as constructing a portfolio with a level of risk that the client is clearly uncomfortable with will not likely lead to a good outcome in the investor’s view.

 
Risk Tolerance Questionnaire
Circle the letter that corresponds to your answer.

Just 60 days after you put money into an investment, its price falls 20%. Assuming none of the fundamentals have changed, what would you do?

a.  Sell to avoid further worry and try something else.
b.  Do nothing and wait for the investment to come back.
c.  Buy more. It was a good investment before; now it’s a cheap investment, too.
2. Now look at the previous question another way. Your investment fell 20%, but it’s part of a portfolio being used to meet investment goals with three different time horizons.
2A.  What would you do if the goal were five years away?
a.  Sell
b.  Do nothing
c.  Buy more
2B.  What would you do if the goal were 15 years away?
a.  Sell
b.  Do nothing
c.  Buy more
2C.  What would you do if the goal were 30 years away?
a.  Sell
b.  Do nothing
c.  Buy more
3.  The price of your retirement investment jumps 25% a month after you buy it. Again, the fundamentals haven’t changed. After you finish gloating, what do you do?
a.  Sell it and lock in your gains
b.  Stay put and hope for more gain
c.  Buy more: It could go higher
4.  You’re investing for retirement, which is 15 years away. Which would you rather do?
a.  Invest in a money-market fund or guaranteed investment contract, giving up the possibility of major gains, but virtually assuring the safety of your principal
b.  Invest in a 50-50 mix of bond funds and stock funds, in hopes of getting some growth, but also giving yourself some protection in the form of steady income
c.  Invest in aggressive growth mutual funds whose value will probably fluctuate significantly during the year, but have the potential for impressive gains over five or 10 years
5.  You just won a big prize! But which one? It’s up to you.
a.  $2,000 in cash
b.  A 50% chance to win $5,000
c.  A 20% chance to win $15,000
6.  A good investment opportunity just came along. But you have to borrow money to get in. Would you take out a loan?
a.  Definitely not
b.  Perhaps
c.  Yes
7.  Your company is selling stock to its employees. In three years, management plans to take the company public. Until then, you won’t be able to sell your shares and you will get no dividends. But your investment could multiply as much as 10 times when the company goes public. How much money would you invest?
a.  None
b.  Two months’ salary
c.  Four months’ salary
 
SCORING YOUR RISK TOLERANCE
To score the quiz, add up the number of answers you gave in each category a–c; then multiply as shown to find your score:
(a) answers _____ × 1 = _____ points
(b) answers _____ × 2 = _____ points
(c) answers _____ × 3 = _____ points
 
YOUR SCORE_____points
If you scored . . . You may be a:
  9–14 points Conservative investor
15–21 points Moderate investor
22–27 points Aggressive investor