Mutual fund advertisements and public awareness programmes seem to suggest you can determine your risk attitude and choose an appropriate mutual fund to invest to achieve your goals. In this article, we discuss why determining your risk tolerance is not easy.

Risk vs Loss

Risk is the possibility of loss in the future. To determine risk tolerance, you must be aware as to how much loss you can bear in the future.

The issue is our brain is a bad simulator. We cannot easily determine how much of pain we can endure in the future. Often, we overestimate our ability to bear losses.

Therefore, we tend to take more risk than we can bear. So, when risk materialises and investments generate losses, we want to bail out. In other words, our tolerance to loss is much lower than our tolerance to risk.

You cannot determine your loss tolerance level, unless you document your behaviour when you incur large losses. If it is any consolation, even investment professionals find it difficult to accurately determine loss tolerance levels of clients.

Note that regulations in most countries require investment advisers to administer a risk-tolerance questionnaire. There is no-loss tolerance questionnaire.

Overestimating risk tolerance

But why is that we tend to overestimate risk tolerance? For one, we may be suffering from projection bias. This refers to the common belief that if the stock market has gone up in recent times, it will continue to do so in the future.

So, we are willing to brave the market. But when the market declines, loss tolerance kicks in. For another, it could be a simple case of not wanting to give up potential gains. What if you take risk and it pays off?

So, the expected happiness from gains could prompt an individual to take risk. But if the risk materialises, the pain of losses set in. Remember, 20 per cent loss can give us more pain than the happiness we may get from 20% per cent gains.

Conclusion

Determining risk attitude is difficult, leave alone loss-tolerance level. It is best to be mindful that investing in equity is important because having investments only in bonds cannot help achieve your goals.

What kind of equity funds to buy and what should be the asset allocation? A simple approach would be to buy an index fund. We will have a discussion on asset allocation soon.

(The author offers training programmes for individuals to manage their personal investments)

Published on October 21, 2024