While investing, it is your risk appetite and corresponding return expectation that helps you decide which investment product would be suitable for you to achieve your financial goals. Usually, a high-risk investment product gives a high return and vice-versa.
A mismatch between the expected ROI and risk appetite can result in a financial catastrophe. So, it is crucial to invest only as per one’s risk appetite. Also, not taking any risk can be risky too as your “super safe” strategy may not be sufficient to even beat inflation!
So, before you start investing, it’s imperative you understand your risk profile, and also the difference between risk appetite and risk tolerance.
Risk appetite vs risk tolerance
Risk appetite refers to the willingness to take an investment-related risk whereas risk tolerance means the actual ability to take that risk. For example, someone might have an appetite for 5 samosas, but in actuality cannot have more than 1 due to a health condition. If they still go on to have 5, the risk of an immediate health complication increases.
As such, there can be a difference between an investor’s stated “risk appetite” and their actual risk tolerance depending on their current situation and other larger financial trends.
Factors that impact risk appetite and risk tolerance
Your age, experience and skillsets may determine your risk appetite. Generally, higher the age, lower the risk appetite and vice-versa. So, people in their 20s will have more risk appetite in comparison to people who are close to their retirement age as the former’s investments have more time to recover and grow.
More experience and higher skillset mean you know more about the subject; therefore, your enhanced knowledge will help you make wise decisions, decrease the risk of your investments failing and in turn increase your risk appetite.
On the other hand, risk tolerance is affected by factors such as income, expenses, liquidity, financial goals, insurance, etc. For example, your high expenses may not leave you with sufficient funds to invest despite your high risk appetite, plummeting your risk tolerance. Similarly, if you’ve taken sufficient safeguarding measures (for example, if you have in place a considerable emergency fund and sufficient health insurance and life insurance cover) your risk tolerance will see a boost as you’ll be in a better position to go for a risky but more lucrative investment option.
Do you know under which risk profile category you fall into?
Investors can generally be grouped into three categories based on their risk profile – conservative, moderate and aggressive.
If you’re someone who is risk-averse and prefers investing in low-risk investment instruments, you’re a conservative investor. Conservative investors are more inclined towards fixed-return instruments like fixed deposits, small savings schemes, etc. People tend to become conservative investors when they’re close to their retirement age as they don’t want to risk denting or losing their retirement corpus.
On the other hand, if you’re someone who is well-settled in their career and have a number of pre-retirement financial goals to achieve, you may fall into the category of moderate risk investors. Such investors will look to achieve higher returns by going for risky investments to meet some of the goals while sticking to low-risk low-return instruments for the remaining goals. Therefore, moderate investors can focus on a balanced risk-return ROI. Such investors usually prefer investing in a large-cap or balanced mutual funds, Unit Linked Plans, Gold Exchange-Traded Funds or Gold Sovereign Bonds.
Lastly, many young investors can be categorised as aggressive investors as they possess a greater risk appetite. They can focus on high-risk and high-return investment products to earn a higher ROI. Such investors prefer to invest in products like a small and midcap mutual funds, shares, equity mutual fund SIP, etc.
How to manage risk?
Start early: Starting to invest early in your career is perhaps the best advice to help manage the risk component. The more time you get to invest, the better would be your efficiency to manage risk.
Diversify your investments: Spreading your investments to multiple instruments with varying degrees of risk is another tried-and-tested strategy to cut down on combined risk of your entire portfolio. So, if any of the asset class you’ve invested in is not performing well, the other investments may help you realise the expected ROI. You can invest in equity products, debt class, gold, real estate, etc. to diversify your investment portfolio.
Think long-term: Always focus on long-term investment, because in the short-term you don’t have a margin for error. In the long-term, you can switch investments if a particular asset is not performing well.
Go SIP: Investment products provide a return based on the prevailing market situation, therefore instead of making a one-time investment, try to invest in regular intervals. A regular investment like a Systematic Investment Plan (SIP) helps you to do rupee cost averaging when there is a negative correction in the market, and you can quickly come into profit when the market recovers.
Keep reviewing: Finally, it is important to review your risk profile from time to time and accordingly adjust your investment portfolio to ensure they’re always aligned with your financial goals.
So be mindful of your risk profile and make the most of your investments by managing the risk component.
The author is CEO, Bankbazaar.com