Very often, people jump into investment products offered by investment relationship managers simply by looking at the rate of return offered. However, there is a host of other factors that investors often fail to assess. One of the most important factors among all is risk. We think a lot before buying a smartphone. We check out features, performance and last but not the least, price. We always try to strike a balance between utility and price.
Similarly, in investments, along with returns, risk remains one important consideration. Almost all investment products are exposed to various risk, only the degree differs. Therefore, it is very important to understand your risk tolerance level before you subscribe to any financial product.
Saving and investing involves a variety of risks, for instance, the risk that an institution will fall (default risk), the risk your money will not keep up with rising prices (inflation risk), the risk that comes with share prices going up and down (volatility risk), the risk that you could have earned better returns elsewhere (interest-rate risk).
Most investors make a mistake of using these two terms -risk appetite and risk tolerance- interchangeably. It is important to understand that while the term risk appetite refers to your willingness to take risk, risk tolerance implies to your ability to do so. You might be willing to go sky diving (risk tolerance) but you have to be physically fit to do so (risk tolerance). On similar lines, as an individual you may be a risk taker, and probably would not hesitate to put your money in risky avenues. However, is your present circumstance able to handle a loss that may arise from the venture.
Let’s help you get an idea of your risk appetite:
Step 1 – Know what you can afford to lose
Ask yourself what would happen if you lost some or all of the money you’re putting into investments.
This will depend on your circumstances and how much of your money you’re investing. Think about people who depend on you financially and any other important financial commitments you need to be sure of meeting.
Step 2 – Work out your goals and timings
Your saving and investing choices will depend on your goals and timescales. The bigger your goal in relation to the assets or income you wish to invest, the greater the rate of return required to beat inflation and hit your goal. Short-term goals – under one years – are best saved for in cash and liquid short term investments. You don’t want to be worrying about the state of the financial markets when you need your money to be readily accessible. However, cash savings run the risk of not keeping up with rising prices (inflation risk). With longer-term goals, it’s more usual to put your money into investments that have a better chance of giving you inflation-beating returns, such as shares, real estate backed investments. So if you have a long-term goal it makes sense to be prepared to take on longer time horizon for the opportunity of higher returns.
Step 3 – Understand your personal risk attitude
Risk attitude is subjective and is likely to be influenced by current events or recent experiences. Most people are not comfortable with the idea of losing money. On the other hand we might regret it if we’ve been very cautious and our long term investments don’t produce the returns we need. You can keep risks in line with your risk appetite by spreading your money across a range of different investments.
Your risk appetite is also influenced by the following:
- Age: Investors risk appetite generally declines with age. This is primarily because as the investor matures in age and reaches retirement, he psychologically cannot tolerate high volatility in his portfolio. Any dips in his investment value will lead to erosion of his retirement corpus. On the other hand, a young investor can comparatively take higher risks as he has a larger number of working years before he retires. He has ample amount of time and opportunities to recover from any possible setbacks in the value of his portfolio.
- Your past experience: if you have a good experience about any product in the past, you tend to become more comfortable with repetitive buying. Those who have earned substantially high returns previously would have a heart to take more risk.
- Knowledge: This is one those rare assets which may never lose their value. A thorough knowledge about something increases your awareness. Becoming aware about good and bad effects completely would push your risk appetite up. The more aware about an investment option, the more likely your risk appetite increases.
Having understood the factors that influence your risk appetite and tolerance level, you can proceed to take this risk tolerance quiz
In our next article, we will be introducing you to the different investment classes defined by their inherent risks.
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