Wednesday, July 17, 2013

How to evaluate your risk appetite and risk tolerance level?

Under the present market conditions, one thing has become certain. There is nothing known as a 'free lunch'. Everything comes for a price, including returns on your investments. In order to make high gains, you have to be able to digest high volatility. In other words, a high return generated on your investment is a premium you earn for bearing high risk. This is known as risk-return trade off.

Very often, people jump into investment products offered by relationship managers and investment agents simply by looking at the rate of return offered. However, at this point 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. If we were only sensitive to prices we would never buy phones costing us Rs 50,000. We always try to strike a balance between utility they (smartphones) offer vis-à-vis their 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 blindly hawk into financial products.
The next question which comes to our mind is- how do we evaluate our risk appetite and risk tolerance level?

Most investors make a mistake of using these two terms (viz. risk appetite and risk tolerance) interchangeably. These are two separate concepts which must be analysed individually before one plunges to take investment decisions. 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 love sky diving, bungee jumping and so on but you must also be physically fit to participate in such activities. 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, it is imperative to take into consideration your present situation before taking investment decisions.

The following factors will help you to measure your risk tolerance level

  • Income: Your income is an important determinant to gauge your risk tolerance. If your income is high enough, you will not mind taking higher risks while taking investment decisions and vice-versa. This is because small setbacks in your portfolio will not affect your ability and capability to invest.

  • Expenses: Your outgoings also influence the risk which you can afford to take while investing. Thus although you may be having a high income, but your disposable income is petite you could be refrained from taking highrisk. Hence it is imperative for you to streamline unnecessary expenses, so as to keep your financial health in pink.

  • Financial Responsibilities: such as children's education and marriage, and your current financial situation are vital in deciding your risk taking ability. Only if you have enough funds to meet your short term goals, can you expose your portfolio to high volatility.

  • Nearness to goal: The time left for the realisation of financial goals also determines your risk appetite. If you are adequately away (in terms of number of years) from meeting a financial goal, you can afford to expose your portfolio to higher risk which might enable you to create more 'wealth' in the long term. But if your financial goal is drawing nearer, it would be more prudent for you would be a risk-averse investor to preclude wealth erosion.

  • Sufficient Liquid Cash needs to be saved in your bank account to sustain your present lifestyle for the next 12-18 months incase you lose your job or for any other financial emergencies.

  • A suitable Life Insurance Cover is essential to provide financial security to your dependents in case of any untoward event. This will help your family in paying off your debts and also meeting household expenses. An inadequate life cover will definitely lower your risk tolerance as you would need to generate predictable flows on your investments to protect your savings from the risk of loss.

  • Health Insurance ensures that you get appropriate medical care when you need it. An accident or illness can cause a huge hole in your savings or even worse, create a huge liability, if you are not insured. If you are not covered by a good health insurance policy which can take care of your hospitalization and other expenses, you cannot afford to have a high risk tolerance.

Risk appetite is backed by a rationale considering risk determinants such as 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. If you have earned success in beating champs in derbies you wouldn't mind betting even on dark horses. Same goes true in case of investments. 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. In primitive stage of development, man knew little about fire and was as apprehensive to it as any other animal. However, once he become aware about possible positive changes that fire may bring to his life; he started using it to his benefit.

Hence a combination of risk tolerance and risk appetite should be considered before making any financial decisions.

Often investors bet on the market based on 'tips', which may not have generated out of a sound investment rationale or research backing. The greed and thrill to generate alpha, leads them to blindly hawk into investment opportunities without taking into consideration their viability. This ultimately proves detrimental for their investment portfolio. You should be wary of opportunities which harp about returns but do not emphasis much about the risk involved. So the next time you hear or read of investment opportunities and avenues ask yourself a simple question - "Does this investment opportunity or avenue suit my risk profile, although it may deliver luring returns?"

We have established earlier in this article that generally there is a direct correlation between risk and return. However, with the help of sound investment processes and correct asset allocation (based on your risk appetite and risk tolerance) you can optimise your returns with a relatively low level of risk.

Investors whose objective is to achieve long term capital appreciation and have an aggressive risk appetite can consider investing a greater portion of their portfolio in risk assets (upto 70% in risk assets such as equities and related instruments, and the remaining 30% in safer asset classes such as debt and cash instruments). The long time horizon remaining for the realisation of their financial goals will help them to offset any possible losses that might generate due to volatility. Moderate Investors, who aim at providing some stability to their portfolio along with capital growth, can invest upto 60% in equities and balance (40%) in debt and cash. Conservative Investors', who prioritize the protection of their capital and are risk averse, may allocate upto 70% in debt and cash, while the rest can be diversified by investing in quality equity instruments. However, before you follow this ideal asset allocation, be cognisant about the aforementioned facets which we discussed.

  We believes that with help of sound financial planning which also considers suitable asset allocation you may optimise returns on your investments without disregarding the element of risk. 
Source : PersonalFN

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