Volatility has gone up - watch out! Yes, increases in volatility can hurt you, but changes in your risk tolerance will also cause you financial harm. Traditional finance assumes that your risk tolerance is fixed. Don't believe it. The behavioral biases discussions which have been the rage in finance is focused on how risk appetite or tolerance changes with your perception of the market environment.
Your risk tolerance or risk appetite may be the most important determinant of how much you can or will lose from investing. Your acceptance of volatility or how much risk you are willing to take at a given time can change with your level of confidence, your processing of information, and other factors that have been described as behavioral bias. Since your appetites are hard to measure, we often discuss these issues in terms of biases.
Your risk appetite is the total amount of risk per unit of return you are willing to accept and is generally thought of a relative concept for investors. Your risk tolerance is the total amount of lose an investor is willing to take. This could be viewed as the maximum amount of risk to be taken by an investor. There is a risk progression. You identify your risk appetite which can tell us something about our risk tolerance, but beyond a risk threshold, we will not be interested in even taking the bet.
If your risk appetite is constant for a given return, you will cut back your exposure when there is an increase in volatility. A key problem with investors is that there risk tolerance is constantly changing or adapting based on a whole set of factors. This means that tolerance may increase or decrease at the wrong time. If you hang-on to losers, it is because you may become more tolerant to risk when you think you have to take the actual lose. If you sell your winners, your risk appetite is decreasing after you have some gains. There is a difference between risk acceptance and risk acknowledgement. When these diverge, you are in for some potential trouble.
Your risk tolerance changes with age and experience. It is a function of whether you are part of a group or alone in your decision to invest. It will increase if you have a successful streak of trades or a series of losses.
Of course, the story is a little more complex based on your expected return and risk, but you can easily see that if you are not careful, you may be adjusting your risk based on your current perceptions on not on long-term behavior. The benefit of a model or systematic trading is that it can ensure risk appetite and tolerances are measured and fixed. Knowing the risk you are facing is not enough for keeping you safe. You have make sure you do not change your appetite after the investment is initiated.
Your risk tolerance changes with age and experience. It is a function of whether you are part of a group or alone in your decision to invest. It will increase if you have a successful streak of trades or a series of losses.
Of course, the story is a little more complex based on your expected return and risk, but you can easily see that if you are not careful, you may be adjusting your risk based on your current perceptions on not on long-term behavior. The benefit of a model or systematic trading is that it can ensure risk appetite and tolerances are measured and fixed. Knowing the risk you are facing is not enough for keeping you safe. You have make sure you do not change your appetite after the investment is initiated.
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