Think of a game of poker. Certain players invest all their chips and go ‘all in’ while others may only add a few of their own to the pool. The former player may live for the excitement of the unknown (and the unwavering faith in the cards at hand) while the latter may want to watch how the game plays out before putting in any more funds.
Neither of these players is wrong. The former may win exorbitant amounts of the cash, and so may the latter (in the long term, after evaluating all potential moves).
A game such as this can exemplify one thing quite clearly – some investors take bigger risks than others.
In terms of investment, risk tolerance refers to the amount of risk that an investor is willing to take in order to grow their funds. In order to help investors make astute decisions, many investment products offer their risk profile – that is, the degree of threat that a fund can face. Based on their risk appetites, the investor can then decide which funds make the most sense for them.
However, though this may sound quite straightforward, it rarely is. This is because funds with higher risks also offer higher ROIs while funds with lower risks offer lower ROIs. Novice investors can find themselves getting carried away by greed and the thought of growing their wealth quicker than expected.
So, before you begin jotting down the funds that you are interested in, you must first identify your own attitude towards risk as well as, most importantly, your ability to handle the same.
Identifying Your Risk Tolerance
When risk-averse investors take risks they are not comfortable with, they spend their investment term riddled with anxiety and become more prone to making decisions that are motivated by fear rather than market performances. This can mean disastrous losses and a bad investment journey. The best way to avoid the same is to identify your risk tolerance before making any investment decisions. The following factors can help you do the same:
What is the term period you are considering?
Often, time can be a crucial factor when it comes to the risks we are willing to take. If you are investing your funds for a set short-term goal, then you do not have the time to take risks and then wait for them to level out. Short-term goal oriented investments require caution that is geared towards ensuring you can earn enough funds to meet that goal. Thus, considering the time that you have on your hands is the first step in determining whether you should even take a risk, even if you have the appetite to do so.
When are you planning to retire?
When growing wealth for the future, your retirement age plays a vital role in determining the kinds of funds you want to invest in. If you are gunning for early retirement to pursue a dream, the chances are that you need high ROI investments to make them happen. If you are planning to retire in your 60s, then you must invest in funds that double as pensions for the future. In both cases, the risk an investor faces is vastly different. High ROI funds come with high risks, while funds geared towards growing a pension are generally safer.
How do you react to adversity?
Understanding the way adversity impacts your decision-making is crucial. Does panic sharpen your mind and lead to brilliant performance under pressure? Or do you find yourself despairing and wishing it was all over? Your own reaction to life events can indicate your appetite for risk to a very large extent.
Types of Investors by Risk Tolerance
Within the financial world, there are three main terms managers use to categorize investors and the types of risks they are willing to take. These are as follows:
An aggressive investor is someone who follows the movements in the market and understands finance quite well. Such investors are willing to take risks and often prefer active investment strategies to passive ones. These investors are not too worried about investing in small, unknown companies and are generally motivated by their own beliefs in the company’s product. They do not mind taking risks.
A moderate investor is someone who is certainly willing to take risks, but will not go out of their way to do so. Their approach to investments is generally a balanced one, with a collection of high and low-risk investments in their portfolio. They plan both, long and short term investment horizons and may have funds that mature in 5 years, as well as funds that mature in 15 years. In terms of the types of companies they like to invest in, they prefer larger, established enterprises over smaller, ‘undiscovered’ companies just waiting to blow up.
A conservative investor is someone who is generally risk-averse. They choose safe options such as FDs in order to ensure that they do not have to deal with any market volatility. They are more than willing to sacrifice earning very high ROIs in order to gain the comfort of knowing they have no risk to face.
Ideally, no matter what your risk appetite is, you should ensure that your portfolio is well diversified. This way, you can have the best of both worlds and watch your wealth grow without any fear of losses.