Investors are entitled to a level of return that is commensurate with their risk capacity. Therefore, the importance of the measurement of risk capacity in the investment process cannot be understated. For example, if an investor selects a portfolio that is overly conservative, the danger is that when the stock market starts to rise rapidly he adopts a more aggressive stance and increases his risk exposure beyond his risk capacity. At this level, the higher volatility ultimately has the effect of scaring him back to a more conservative risk exposure.
The five risk dimensions of individual risk capacity are:
i. Time Horizon and Liquidity NeedsThis dimension estimates how rapidly investors may need to withdraw money from their investments. The longer an investor holds onto a risky asset with at least a twenty year record of associated returns, the less chance there is of obtaining poor cumulative returns.
ii. Attitude to RiskThis dimension estimates aversion or attraction to risk – defined as “the possibility of loss” – and addresses an investor’s ability to withstand the fluctuations in the value of any investment that is subject to risk. The longer an investor holds on to a risky asset with at least a twenty year record of associated returns, the less chance there is of obtaining poor cumulative returns.
iii. Net WorthThis dimension estimates the investor’s capacity to take various levels of risk. A high net worth provides a cushion for the uncertainty of future cash needs. Because life is uncertain we can never be certain of tomorrow’s requirements. However, the more assets an investor has in reserve, the higher his capacity for risk.
iv. Income and Savings RateThis dimension estimates the investor’s excess of current income and ability to add to savings. The higher the score, the more likely it is that the investor will have a higher discretionary income available for investment and also a greater cushion against future emergency cash requirements.
v. Investment KnowledgeThis dimension estimates the investor’s knowledge about investing in general and, more specifically, the relationship between risk, return and time.