Risk Tolerance / Loss Tolerance

What’s your risk tolerance? How do you identify it? Both are important questions that I doubt investors spend a ton of time thinking about at first. They’re also abstract questions thanks to all the convoluted definitions of risk. During an interview, Daniel Kahneman was asked his thoughts about identifying risk tolerance. He suggested a better way to frame the question: what’s your loss tolerance? How much loss can you endure before hitting the breakpoint where emotions push you to change your portfolio? By reframing it, Kahneman forces you to think in terms of Rupees, not percentages. That may not seem like a big difference, but emotions trigger in Rupees terms. Lost Rupees can be quickly equated to missed goals and dreams — less money to spend, a canceled vacation, a postponed retirement — that make you nauseous in ways that a percentage won’t.

Kahneman went on to explain its importance in minimizing regret and how to fit it into portfolio construction.

The main question that he found useful to ask when someone is very wealthy is how much loss is the individual willing to tolerate? That is, what fraction of their wealth are they actually willing to lose? It turns out that fraction is usually not very large. That’s a very important parameter. How much do they really want to protect as much as possible, and how much are they willing to consider losing? That varies a lot among individuals. By and large, the very wealthy mostly want to protect their wealth, and they’re willing to play with a small fraction of it. That is the fraction they are prepared to lose, but it’s not a large fraction. So they’re loss averse, not risk as such.

For the individual who is very concerned about losses, he thinks stop-loss order is certainly a good approach. That’s the major question you want to ask the investor. How much are willing to lose? Then you have to take steps so that they won’t lose more than they are willing to lose. That’s in effect a stop-loss policy.

Daniel Kahneman is an Israeli-American psychologist and economist. His notable work is in area of the psychology of judgment and decision-making, as well as behavioral economics. He was awarded the 2002 Nobel Memorial Prize in Economic Sciences.