If in the past, you have been successful with any investment product, you would not mind taking a further risk in the future as well. But if you have encountered unpleasant experiences with any investment, this would lead you to stay away from it.
By Jimmy Patel
When investing, while most of us endeavour to earn good returns, we should not just look at the returns but the risk as well. Keep in mind, high-risk does not necessarily translate into high returns always. As a prudent investor, adding investment avenues that are in congruence with your risk profile should not be disregarded.
So, how to go about determining your risk profile? Well, it is a function of your risk tolerance and risk appetite.
Risk tolerance is the ability to take the risk, which depends on the following factors:
Income: If you are earning well, receiving bonuses, increments and career prospects look bright you may not mind taking higher risks. Conversely, if earning an income has been a challenge and income is not growing enough, such setbacks may reduce your risk tolerance. So, broadly the income you earn has a positive correlation with your risk-taking ability.
Expenses: Your outgos influence the risk you can afford to take while investing. You may have a high income, but if your disposable income is low, it will discourage you from making a high-risk investment. So, if you streamline unnecessary expenses, it will leave you with a sizable investible surplus.
Financial responsibilities: The number of dependents and the financial goals you are addressing such as children’s education, their wedding expenses, your retirement, etc., also influences your risk tolerance level. Higher the amount of responsibilities to shoulder, lower is your risk tolerance
Time-to- goal: This refers to how close you are before the envisioned financial goals befall—days, months or years. If you are sufficiently away in terms of years (over three years) from meeting your financial goal, you may afford to take exposure to risky asset classes. On the other hand, if the financial goal is closer (less than 2-3 years away), the risk tolerance may reduce and then exposure to high-risk assets is not suggested.
Contingency reserves: This refers to the rainy-day fund you have built to address exigencies. If a sufficient amount is held as contingency (ideally 24 months of regular monthly expenses, including EMIs on loans), that may allow you to take more risk. But if it is inadequate, that would have a bearing on your risk tolerance.
Insurance cover: Inadequate life cover would lower your risk tolerance. Besides, optimal life insurance cover is essential to provide financial security to your dependents in case of any untoward event. Likewise, optimal health insurance cover is necessary to avoid utilising your savings and investments, in case of a medical emergency.
Speaking of risk appetite, it refers to your personal willingness to take the risk as per your age, past experience, and knowledge.
Age: At a younger age, usually the risk appetite is high. However, as age progresses and there are responsibilities to shoulder, risk appetite may reduce.
Past experience: If in the past, you have been successful with any investment product, you would not mind taking a further risk in the future as well. But if you have encountered unpleasant experiences with any investment, this would lead you to stay away from it.
Knowledge: Knowledge and capability to apply it to make well-informed decisions gives the courage to take a calculated risk. Higher the understanding of financial markets and products, higher the risk appetite.
Maximise your investment returns by mitigating risks. With the help of a financial guardian, craft a strategic asset allocation and diversify your investment portfolio.
The writer is MD & CEO, Quantum Asset Management Company