Not too long ago, I had an encounter with a retired medical doctor who used to be a professor at the University Teaching Hospital Ibadan in Nigeria, and she spoke to me about the need to eat according to my blood type. Her argument and advice were taken from the playbook of the idea developed and created by naturopath, Peter J D’Adamo.
According to D’Adamo, the foods you eat react chemically with your blood type. This, according to him, means that if you eat food designed for your blood type, your body will digest such food more efficiently for better results: more energy, weight loss, and disease prevention, among others.
In the same way that D’Adamo has theorized on eating according to ones’ blood type, investment and finance experts have opined that investors should invest according to their risk chemistry— their risk tolerance and risk appetite, to be specific.
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What is Risk Tolerance and Appetite?
The essence of advocating that people should invest according to their risk appetite and tolerance is because people react differently to risk and as a result, a portfolio that is good for investor A may not necessarily be good for Investor B. While some investors or people are always willing to accept risk, others are always willing to reject it.
Risk tolerance is the degree or extent of variability in investment returns that an investor is willing to withstand. In the same way, risk appetite is the amount of risk that an investor is willing to accept before putting in place measures to mitigate or reduce investment risks.
While those that are willing to accept risk are said to be risk-tolerant or risk lovers, those with the wiliness to reject risk are the risk averters or risk haters, with those in the middle being classified as the risk indifferent people. Those that are risk-tolerant tend to be aggressive, while those risk haters are usually conservative investors. The reason why some people are more willing than others to take risks can be associated to their biological makeup, upbringing and other life experiences. In most cases, risk tolerance and appetite is best discovered by completing financial risk assessment questionnaires which are usually available in major fund manager websites across the globe or by examining your reaction to certain financial and non-financial events.
Factors Affecting Risk Appetite and Tolerance
Unlike blood type that is easily ascertainable through blood work, risk appetite and tolerance are not so easy to uncover, because they depend on a whole lot of factors, from demographics to the level of education and everything in between.
Demographics: Studies and researches have shown that risk tolerance is associated with such things as wealth, education, age, gender, birth order, marital status, and occupation.
Gender: Your gender seems to affect your risk tolerance. While it has been known that men are more risk-tolerant than women, that trend seems to be changing gradually, as women are beginning to take on positions and activities that were hitherto considered reserved for men.
Age: In addition to your gender classification, your age tends to play a role in your investment risk chemistry because the older you get, the less you would love to take a risk. A study conducted by Investment Company Institute in the US found that the average ages of their low, moderate and high-risk tolerant investors were 60, 51 and 42 respectively.
In an article entitled “Understanding and Assessing Financial Risk Tolerance: A biological Perspective,” it was said that an enzyme, monoamine oxidase (MAO) is found in higher concentration among the risk-averse and that the level of MAO increases with age. So, this implies that the older you get, the more risk-averse you tend to become. The extent to which this holds is questionable though, given that some old gurus like Warren Buffet and George Soros still take major risks.
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Another reason the younger ones are more risk-loving is that they have more time to recover from investment losses than the older ones. That is why fund managers invest in fixed income instruments for the retirement ready investors and equities for the vibrant youths.
Marital Status: Your marital status also affects your investment risk disposition in that people who are single tend to have more risk appetite than married people. In addition to your marital status, the family make-up affects your disposition towards investment risk. A married but childless couple will be more daring, or more disposed towards risk than married couples with children, especially when the children are quite young.
That is why more people buy life insurance soon after they begin making babies. Your financial position in the family affects your risk tolerance level. The only breadwinner of the family will be less risk-tolerant than a breadwinner in a family where there is more than one person to depend on financially. In the same way, the number of dependents you have will affect your risk tolerance.
The more the people that depend on you, the less risk appetite you will have. Your salary level, occupation, level of education, number of years in your current job, your net worth, as well as your ownership of financial assets like retirement savings, insurance annuity, real estate, among others, will also affect your risk characteristics.
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Level of education: The more educated you are, the more investment risk you would like to take, all other things being equal. This is because the more educated you are, the more prospect you have to recover from investment losses.
In part two of this article, I will take a specific look at how risk lovers and haters react to different events.