Risk Appetite Differs From Person To Person-And How It Can Be Assessed
Everyone likes to see their money grow, but when you are invested in the markets you must bear in mind the all-pervasive factors of risk. There are a variety of risks that an individual is exposed to, while investing. These are, the risk of share prices dropping or rising drastically (volatility risk), the risk of the fact that your investments will not keep up with the rise in prices (inflationary risk) and the risk of your investments could have earned a better rate of interest if they had been invested in any other instrument (interest rate) risk.
Investing is an intensely personal thing and each investor must enter the markets with the clear perception that these risks will always remain. However, what differs from investor to investor is his risk appetite or his capacity to bear loss. No two people can have the same financial goals, therefore, it is natural that their risk appetite too is different from each other. Successful investing is all about striking the right balance between these risk factors.
The key to making good investment decisions is therefore to assess your risk appetite correctly. Your risk appetite depends upon the financial goals you have set out for yourself, the time horizon, you have given for your investments, your circumstances in life (job, life, responsibilities) and finally your attitude towards risk.
As you can see the factors that determine the risk appetite of an individual varies widely from person to person. Therefore, each person much goes about assessing his or her own risk appetite before making any investment decisions. Here are some basics of how one should go about assessing his risk appetite.
Step one:
Chalk out your goal and time horizon:
The investment choices you make will depend upon your goals and your expectations of returns within a certain time frame. In order to achieve your goals, you must strike a balance between taking no risk at all and taking too much of a risk.
If you have short term goals (under five years) you need to keep investing your money in instruments where you can readily access your funds when you need them. The best choice in such situations may be cash products. However, in such case you do expose yourself to some inflation risk as your savings will not keep up with the rising prices.
On the other hand, if your goals are long term in nature, stock markets are your best bet as a longer time horizon gives you a better chance of beating inflation and maximizing your returns. Taking a higher volatility risk thus makes more sense when you are trying to meet your long term financial goals.
The other important aspect of time horizon is to change your risk balance when your long term goals are in sight. A few years before the date of your goals you must make a deliberate attempt to lock in your gains and protect your portfolio against sudden market crashes. This is the time to reduce your volatility risk and reallocate your assets into low risk instruments.
Step two:
Be aware of what you can afford to loose
The litmus test of your risk appetite will be to ask yourself in what situation you would find yourself if you put all your money at stake and lose it all or a portion of it. Think about your commitments, responsibilities and the people who depend upon you before you arrive at an honest answer.
Step three:
Understand your attitude towards risk
Attitude towards risk is something that is very subjective and must play an important role in your portfolio construction. While nobody likes to lose money on their investments, some people find the idea of loss distressing, others are a little more relaxed about such issues and can take some losses in their stride. Risk profiling thus becomes a key factor when making investment decisions.
Therefore, in conclusion, it must be said that risk becomes a pillar on which investment decisions rest. Only after you have truly understand your own risk profile, you or your financial advisor may go ahead with your portfolio construction. By spreading your risk over a suitable range of investments, you can keep your risks aligned with your risk profile.