Everything in life has a risk-return trade-off. The higher the returns from a particular investment, the higher will be the risk involved. This risk-return trade off is applicable not just for investments, but for all activities in our life. Although risk plays an important part in taking investment decisions, not many people are aware of how to determine this. It is important to differentiate between risk appetite and risk tolerance. These two are mostly used by investors interchangeably. It is crucial that you understand that risk appetite means your readiness to take the risk and risk tolerance implies the ability to do so. To draw an analogy, you might love bungee jumping (which refers to your risk appetite), but you must also be physical fit enough in order to perform it (which is tantamount to your risk tolerance). While risk appetite differs from person to person, risk tolerance is usually estimated keeping in mind the present financial circumstances and other factors of the individual.
Here are a few factors which will help you determine your risk appetite –
- Age – An individual’s risk appetite generally reduces with age. As one nears retirement, he would like to secure his retirement corpus and would like to minimise the volatility to the portfolio. On the other hand, a younger person will have a higher risk appetite to invest in equities and higher risk investments, as he has sufficient time to recoup his losses if need be. This implies that he has a higher risk appetite in his 20s as compared to what he might have when he nears retirement. Although this is generally true of most investors, there are some exceptions where age does not determine the risk appetite, and a person may continue to have a high or low risk appetite throughout his lifetime.
- Experience – If you have more experience in investing in a particular class of investments, you are likely to have a higher risk appetite for such investments. This is because of the comfort level which sets in with repeated buying. When you have earned high returns in the past, you would be willing to take higher risk.
- Knowledge – Having a deep knowledge and understanding regarding schemes and investments will increase your awareness, which in turn increases your risk appetite. If you are aware about the latest schemes and their working, you will be more compelled to try out your luck in it.
As mentioned earlier, a person’s risk tolerance is very different from his risk appetite. Here are a few factors which can help you determine your risk tolerance:
- Income – This is the biggest factor to establish your risk tolerance. If you income is quite good, you won’t hesitate to invest in various schemes because a little financial set back will not really affect your financial situation in any way.
- Expenses – Even if your income is high, if your expenses are high you might end up saving very little. As a result, there is doubt and fear taking a decision regarding investing. This implies a lower risk tolerance. It is important to cut down your expenses wherever possible in order to keep your financial health intact.
- Financial goals – If you are burdened with any short term goals for which you have not planned the financing, then you will not be able to invest much, considering most of what you are earning is spent on such goals. In such a case, the risk tolerance is said to be lower than a scenario where you have your goals planned and there is no hesitation in investing. Nearness to goals also determines risk tolerance. If your goals are long term in nature, you can expose yourself to higher risk investments, than if your goals are for the short term.
- Liquid cash – If you have enough liquid cash accumulated in your account in order to support you for a year or two in case of emergencies, it could be alright for you to make investments. If your lifestyle allows you to take such a risk, then the risk tolerance is high.
- Insurance cover – Be it any form of insurance cover, if you are sufficiently covered, then you are more willing to take a risk in investments. For example, if you have sufficient fire insurance to cover your business, you can risk investing excess funds which you have, compared to not having a cover for threat of fire. Similarly, in the case of health insurance, if you do not have sufficient cover, sudden medical emergencies or accidents could burn a big hole in your savings and prove to be a heavy liability. On the other hand, if you are insured well and can handle the expenses of sudden hospitalization then this results in increased risk tolerance.
In order to make a wise decision about investments, you should be able to determine your risk appetite and risk tolerance before venturing into anything.