Risk and investments are like two wheels on a bicycle. They help the rider, i.e. the investor, reach their destination. Without taking risks, you cannot earn higher returns. Without taking risks, you may earn a fixed amount of return or guaranteed return, but to grow your investment significantly, you need investments which can offer higher than fixed return instruments offer. However, the question is how much risk to take and here are three factors of risks analysis:
1. Risk Appetite
2. Risk Capacity
3. Risk Tolerance
Risk Appetite
Risk Appetite can be defined as a person’s mentality to take risks or attitude. It is subjective to the investor and his attitude towards investments and life. An investor can be a risk-taker or risk-averse. A risk-taker can be again categorised as an aggressive investor willing to take higher risks to increase his chances for higher returns. Then comes the moderate risk taker, who keeps trying to balance between risk and return and then there are conservative or risk-averse investors who want to take a very low risk or invest in risk-free investments.
Risk Capacity
While risk appetite is about the investor’s thought process, risk capacity is about the investor’s financial standing. Risk capacity is measured by the investor’s earnings, assets, liabilities, responsibilities, and financial goals. A person can be a risk-taker, but he may not have the risk-taking capacity, while on the contrary, a person even having financial backup may not willing to take risks. Read here to get insights on How to choose the right mutual fund for you?
Risk Tolerance
Risk tolerance is the quantitative form of risk appetite. It is the amount or level of risk an investor is willing to take. For example, if an investor buys a stock at Rs. 1000 with the expectation that its value will increase. However, if the price goes down, which is opposite to his anticipation, he decides to wait till Rs. 900. However, if the price breaches this Rs. 900 mark, he will sell the stock. So, the risk tolerance level is Rs. 100 or 10% Read to 10 Books to Enhance Your Mutual Fund Investing Journey! gain knowledge.
How to analyse how much risk to take?
To analyse your risk profile, you need to consider the following:
Family set-up
It’s important to determine the number of family members who have a source of income and can provide financial support. If the number is more, then the risk appetite and capacity can be higher. On the contrary, if there are more dependent members in a family, the risk capacity decreases, and in most cases, risk appetite also decreases. Risk appetite is generally high for young people, while older people want safer investment options.
Occupation
The risk profile also depends on the occupation of the investor. Risk appetite and capacity usually increase if the investor has a secure job.
Assets & Liabilities
To understand risk capacity, one must evaluate assets and liabilities. A person with higher liabilities might not be willing to take higher risks with their money.
Tenure of investment
For considering the risk level, the financial goal’s time horizon must also be analysed. For long-term investment goals, investors can invest in assets with higher risks as the short-term volatility gets averaged out over the long term. However, investing in low-risk investment options can help you reach your financial goal on time for short-term goals.
Why is it important to analyse risk before investing?
The reason behind analysing risk before investing can be described with the old saying – ‘Look before you leap”. You need to align your risk profile with the investment portfolio’s risk profile.
For instance, you want to buy a car within the next two years, for which you want to save and invest. If you invest in small-cap equity funds because of their attractive past performance without analysing the higher risk involved in the investment, you may end up losing the capital or not being able to use it when you wanted to use it. Small-cap funds are highly volatile in the short term and suitable for long-term investment for people with higher risk appetite and capacity 6 THINGS TO DO BEFORE INVESTING.
Thus, whenever you invest, and in whatever instrument, analyse your risk profile and see if it is in sync with the investment’s risk profile.
