Risk and Investor Psychology
Chapter 1 of 4
What risk really means
7 min read
In finance, risk is often defined as volatility, how much returns swing. For a real investor it is more useful to ask two questions: could I lose money permanently, and could I be forced to sell at a bad moment?
Volatility versus permanent loss
- Volatility: prices fall and recover. If you can wait, it is uncomfortable but temporary.
- Permanent loss: a business fails, or you sell after a fall. The loss is then locked in.
Three kinds of risk capacity
- Ability: how much loss you can absorb given your income, savings and obligations.
- Need: the return you require to reach your goals. A bigger goal may force bigger risks.
- Willingness: how you actually feel and behave when a portfolio falls 25%.
The honest allocation sits at the lowest of the three. High willingness does not help if you will need the money in two years.
Risks beyond the market
- Inflation risk: money that does not grow loses purchasing power.
- Concentration risk: too much in one stock, sector or fund.
- Liquidity risk: not being able to sell when you need to.
- Behaviour risk: the damage we do to ourselves by reacting to fear and excitement.
Key takeaways
- Distinguish temporary volatility from permanent loss.
- Match risk to your ability, need and willingness, and take the lowest.
- Behaviour is a risk too.
This content is for education only and is not investment or tax advice. Mutual fund investments are subject to market risks; read all scheme-related documents carefully.