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Risk tolerance is the amount of risk that an investor is comfortable taking, or the degree of uncertainty that an investor is able to handle. Risk tolerance often varies with age, income and financial goals. It can be determined by many methods, including questionnaires designed to reveal the level at which an investor can invest, but still be able to sleep at night.

Risk capacity, unlike tolerance, is the amount of risk that the investor “must” take in order to reach financial goals. The rate of return necessary to reach these goals can be estimated by examining time frames and income requirements. Then, rate of return information can be used to help the investor decide upon the types of investments to engage in and, the level of risk to take on.

There are many questionnaires and software’s available in the market today to measure risk tolerance; but the human mind feasts on irrationality and sometimes, the logic of a well laid out set of questions, graphs, and plans falls in the flush.

After a Financial Planner has spent hours on a client and his family, listening, understanding, educating, probing and twisting questions on their financial needs, goals, risk, attitude towards money, how they have grown up with the values of money and its scarcity or abundance, all this becomes obsolete on the face of changing events, situations.

If you recognize and accept the Power of the Subconscious mind, believe that it is the law of life and belief, of your internalized truths, and when there is a blend between the conscious and the sub conscious mind, then the outcome is harmony in being. The harmony of acceptance and truth that prevails.

Mind you, the power of the sub conscious can be good or bad, but what is important, is that decision is “entirely yours”. The other advantage of the subconscious mind, is that it never takes decisions on the spur of the moment unlike the conscious mind. The feelings and thoughts are internalized and beliefs grown into your system before it overtakes the conscious mind. Therefore, the control, again, is “You”.

Some of the factors which I have encountered that have changed the perception of client’s ability to take on risk are:

1. Wants dominate needs

Very often, man, being the greedy mammal that he is, is led into temptation made available from various materialistic offerings available around us. Today, there is no dearth of eating the best food, choosing the best vacations, buying top end cars, living in the luxury of multiple condominiums, (like one can live in more than one home at a time!). In all this, logic does not prevail. It is the power of our subconscious overcoming the conscious that ultimately leads to the action of suddenly pulling out one’s investments or digressing from the risk level or goal planned for the future.

2) External factors beyond our control affect decision making

Do we have control, if Narendra Modi, becomes our next Prime Minister? Do we have control over the falling rupee? Do we have control on the gold imports in India, Do we have control if Portugal and Spain are facing economic slowdowns? None, of the above factors, you will agree, is in our control. What is in our control, however, is how we react to such situations. To educate, empower and communicate to clients, about the happenings of the market, the acceptance, that these events are not in our control and that they are presumably temporary. What needs to be communicated, is, what can be done to keep the portfolio in place and ensure the final goals laid out are met.

3. Circumstantial / Situational Conditioning

With nature and life changing events, like a divorce, or a marriage, or a mid-life crisis, or a pregnancy, or menopause or a widowed situation, (luckily I have faced all with clients, friends and/or family), people become suddenly more cautious and react completely different from what they have agreed earlier, and signed on the dotted line for!  The hormonal imbalances during such situations drive such irrational behavior, and many people turn defensive, angry, lack self worth, sometimes, even denying what they have mutually agreed upon earlier in terms of their risk appetite, goals or plan and this leads to a change in the whole plan carefully created for them.

Subconcious Mind

4. Daily distractions

Sometimes, it is the daily distractions of say a fight with someone that matters, or a dislike for someone, or lack of feeling of self worth, procrastination or plain boredom, that creates imbalances in our actions and makes our take hasty decisions against what we ourselves have agreed and planned for before.

5. Uncanny truth about retiring

Have you heard some investors telling you, they want to retire tomorrow or yesterday? Well, such clients are probably the one’s not certain about their financial well being and are more likely to take irrational decisions on wealth and health, while deciding on when to retire. Such clients are also prepared to take on any amount of risk to meet the short and impractical deadline. For such clients, risk tolerance is subconsciously very low, but consciously high and this leads to a mismatch between the known and the unknown in decision making process.

While some others who have created their nest egg, or are close to it, the likes of Bill Gates and Warren Buffet, really do not want to retire, or retire only at 80! Some others who depend on other sources of retirement corpus creation, like social security, pension, feel, that saving would suffice for their retiring years, inflation and tax adjusted! They fall weak on the third leg, which is personal savings for creation of corpus.

Some feel, it is not important to save for retirement, until it is imminent, which is far from the truth. The situation gets graver, if the individual is older and still lies in the comfort of not awakening to the reality of their nest egg. This is when generally panic strikes and risk tolerance is thrown out the window in creation of a pool of savings.

6. Emotional ability to handle financial loss

Sometimes, the high risk takers, are also the herd mentality people and want to follow the latest trend in meeting their goals. What happens in such “too good to be true situations” They never last! Along with the mayhem on seeing his portfolio slide, his emotional decision of taking on high risk is demoralized and he resorts to panic selling, without having a clear thought process to his decision making.

7. Changing time horizon of life goals

Haven’t you come across clients, who agree, in principle, that they need to buy a car or a house in 5 years,  and you have designed their risk and portfolio accordingly, but suddenly, they fancy a latest car of the road or a  real estate opportunity, too good to sound true and bam they knock on your door and all the analysis and work on portfolio selections, asset allocation, is stamped with one redemption, irrespective of losses made, exit loads lost, capital gains tax paid or most important at the cost of his other non negotiable financial goals.

Is this all correct? NO… But the human mind loves irrationality!

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Applications of Behavioural Finance & Life Planning

by Gaurav Mashruwala

Sources:

http://www.investopedia.com/ask/answers/08/difference-between-risk-tolerance-and-risk-capacity.asp

http://www.ichoosetoheal.com/downloads/the-power-of-your-subconscious-mind.pdf

http://www.socialsecurity.gov/policy/docs/ssb/v71n4/v71n4p15.html

http://money.usnews.com/money/blogs/the-smarter-mutual-fund-investor/2013/04/02/whats-your-risk-tolerance

 

Authored by,

Dilshad Billimoria

Founder and Chief Financial Planner
Dilzer Consultants Pvt Ltd
Bangalore
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