Is The Desire And The Ability Backed Up By The Need?

Taking risk is an essential prerequisite for all who manage their money. The degree of risk that each of us can digest is a function of our risk capacity and risk tolerance. Risk capacity shows the amount of risk we are able to take. Risk tolerance shows the amount of risk we are willing to take. This has become common knowledge.

But there is another aspect that we forget to take into consideration when assessing our behaviour with investment risk. That being the actual need to take a particular risk. Yes, there are situations where we may need to take less or even zero risk than our ability and willingness to. There may also be situations where we need to take on more risk than we are willing to. And in today's post, I'm going to highlight situations where we would need to understand the balance between the desire to take risk against the need to take risk. This would help us understand whether we would be better served taking on an increased degree of risk, a reduced degree of risk, or maybe even none at all in light of the situations we face.

Let us begin by understanding the difference between the desire and need to take on risk. The desire to take on risk is born when we find an opportunity that offers a potential return commensurate to the risk involved. The need to take on risk shows whether or not taking on a particular risk would make a meaningful difference to our lives. The desire to take on risk simply looks at the tradeoff between risk and return. But the need to take on risk focuses on the relevance of the risk being taken. Understanding the need for risk ensure that we do not take unnecessary risks.

Also, the desire and ability to take on risk does not always create the need to. There are many situations where would come across risks which we would seemingly be able to take. But we may actually be better served avoiding them completely. Let us now look at each of them.

Financially Independent By Age 45

Such people still have around half their expected lifetimes ahead of them. The fact that they have achieved financial independence may induce a false sense of security. This may make them think that they can take risks without having to worry about the implications. This sees them employ their money in extremely risky, unregulated assets such as derivatives and cryptocurrencies. The gains and losses generated by such assets are severely disproportionate. So, any losses suffered may be exponentially greater than the capital they put into such avenues. This could wipe out a significant portion of their net worth. This may threaten their state of financial independence. The consequences would be even worse if losses occur in the later years of financial independence.

Such risks therefore are completely unnecessary. Such individuals may instead hold a portfolio of traditional and market linked assets which are well regulated. The portfolio may be aligned to match the rate of inflation applicable to their lifestyles. That is all they need.

Young Earners With A High Savings Rate

In most cases, such individuals shoulder the least financial responsibilities. This would allow them to have a high savings rate (50% of income or more). The combination of these factors gives them a very high capacity for risk. This sees such individuals run very high allocations to equity (say 80% or more). They may even try relatively exotic products such as factor funds.

But this may not be warranted due to the risk of greater portfolio volatility. Such individuals invariably lack experience with market linked assets owing to their age. This may lead to behavioural immaturity on their part. They must remember that their high savings rate would reduce their dependence on returns. Therefore, their desire to be aggressive with their equity allocation may be misplaced. They instead need to ensure that they manage risk by diversifying their investments across a variety of asset classes. They are better off sticking to simple products like broad market index funds for the equity allocation. This must be done in accordance with an asset allocation strategy and financial plan.

Well Paid But Short Lived Jobs

Those of us who have careers that pay us extremely well over considerable periods of time may feel that money management and taking on investment risk unimportant. This is because all their needs are provided for by their income itself. This sees them put most of their money in highly safe avenues such as bank deposits and other traditional avenues. But they also need to be aware of how long they can retain the potential to earn such amounts.

Take the case of a sports person or a movie star for example. Those employed in these professions earn handsomely as long as they are working. But both these groups of individuals have a set period during which their earning potential is high. Later it may drop drastically. A sports person's earning potential peaks from their late teens until say their late 30s. The average film star would experience supernormal earnings over a period of 10-20 years beginning in their late teens or early 30s.

But their money would have to last them for multiple decades over the rest of their expected lifetimes. And it is extremely rare and difficult for someone to maintain their earning potential over such long periods of time. Therefore, those who earn more than enough to meet their needs at present must also take a moderate degree of investment risk. This would ensure that their money keeps pace with inflation and regardless of earning potential. A portfolio of multiple asset classes and a balanced asset allocation would be enough to achieve this.

Putting It All Together

A reasonable degree of risk is essential to achieve anything of note from our investments. At the same time, it makes no sense to risk a lot or all of what we have to chase what we do not need. This must be kept in mind when evaluating a certain form risk. Risk must only be taken to the degree where our desire to take risk is matched by the need to take it. Risking too little could leave us short of where we need to end up. Risking too much may mean that we have to face deal with irreversible financial setbacks. Therefore we must find the perfect balance between all major aspects of risk. This would allow us to make the most effective financial decisions.