Not too long ago, I did a module on Global Wealth Management which requires me to plan efficient portfolios for high net worth (HNW) individuals. During the course, emphasis was placed on individuals’ willingness and ability to take risk in relation to the return they desire.
In finance world, willingness and ability to take risk belong to 2 different concepts. Willingness to take risk refers to one’s character, education, investment experience, culture and even religion.
For instance, many high income earners only invests in time deposits as they are simply conservative, have negative experience in investment or simply cannot invest due to religious constrains.
On the other hand, ability to take risk refers to quantifiable criteria like level of wealth, investment horizon, liquidity preferences and investment objectives. Thus with a lower liquidity preference and longer time horizon; we are often advised to invest in riskier asset classes to enhance our returns as this translates to higher ability to take risk.
In a bullish market, investors’ ability to take risk increase dramatically as their wealth increase in tandem with the rising market, which eventually leads to high levels of speculation towards the end cycle of bull markets.
However, the above definitions are purely academic. Ability and willingness to take risk, really, is subjective. Nobody truly knows their willingness and ability to take risk until going through at least one bull and bear market cycle. Suitability tests on investments are just a rough gauge at best to determine one’s risk profile.
This is the same concept for inflation figures. Our official figure for inflation is between 2%-4% over the past few years. However, the inflation figure is only true for us if we consume products in the exact same composition of the basket of goods used to calculate inflation.
In reality, every one’s inflation figure is subjective; by the same token, every individual’s risk profile is unique and cannot be measured using standard questionnaires.
I am by nature extremely conservative, yet I invest all my money in stocks and currencies options. This is because of my high ability to take risk, given my long investment horizon and low liquidity preference. Positive investment experience and good finance education has enhance my willingness to take risk, which explains my investment portfolio.
Thus, in order to maximise your return on investment given your risk profile, know yourself better on your ability and willingness to take risk before embarking on your first investment!
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