Saving and Investing inevitably involves a variety of risks, for example:
The risk that a company will go out of operation (company risk),
The risk your money will not keep up with rising cost of living (inflation risk),
The risk that comes with share prices going up and down (volatility risk),
The risk that you cannot get similar returns which you are currently enjoying in future investments (reinvestment risk).
The trick is to strike a balance between these different risks.
What is a good balance for you will depend on:
Need – How well along your way are you towards your financial goal will determine the Need for you to take risk
Ability – How much you can afford to lose without compromising your overall financial position.
Preference – How you will react towards risk, how willing you are to accept risk for the corresponding measure of reward
Out of these three things, your Need and Ability to take Risk are most important.
Your Preference and personal attitude to risk is hard to measure and can change – what feels comfortable one day might not the next, as it might be affected by what you experience, read or heard from a news source or even a well-meaning friend.
Financial institutions often categories potential investors using a Risk Profile questionnaire to determine whether an investor is a Conservative, Moderate, Aggressive or Very Aggressive investor. Useful as they are, it should first be supplemented with consideration towards your capacity for loss and the nature of your investment goals that are most useful in determining a good balance of risk for you.
So, how do you assess your risk appetite?
Step 1 – Know what you can afford to lose
Even if the investment prospectus seems very promising, are you able to subject the result of your financial goal to this single investment? Consider portfolio diversification across asset classes, geography and industries to reduce the impact of potential investment loss.
Step 2 – Work out your goals and time horizon.
We all have certain financial milestones which we can classify into short term (3 years and below), medium term (5-10 years) and long term (Above 10 years).
How we plan for a short term goal should be to priorities capital preservation, and on the other hand, for long term goals we may be able to afford more emphasis towards opportunities for growth. This leaves the medium term goal with a balance between capital preservation and growth opportunities.
Step 3 – Understand your personal risk attitude
Risk attitude is subjective and is likely to be influenced by current events or recent experiences.
When stock markets are rising we tend to be more complacent about market risk, and when they free-fall the gravity of it could knock us out cold. Most people are not comfortable with the idea of losing money. On the other hand we might regret it if we’ve been very cautious and our long term investments don’t produce the returns we need.
As suggested, you can keep your risk attitude in check when you have a properly diversified portfolio.
Would you like to have a clear understanding of your Risk Profile? Comment with a YES below so that I can avail the Risk profile questionnaire to you.
DISCLAIMER: The views expressed here are solely those of the author in his private capacity and not necessarily to the author’s employer, organization, committee or other group or individual.