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All you need to know about Risk Tolerance

Knowing your risk tolerance is necessary to invest in the right financial product.

Every person is unique and so is their capacity to take risk with their investments. As knowing about your passion and interests can help you select the right career path, knowing your risk tolerance is necessary to invest in the right financial product. Many people invest in financial products based on their friend’s recommendation. However, it is not the right way to do as the risk tolerance of your friend may be very different than yours.

But what is risk tolerance?

Risk tolerance is nothing but your ability to take risk with your investments. It helps you to understand your ability to take risk and the willingness to take it. As investing is more about your emotions and less of maths, understanding of your risk tolerance will help you to steer clear of emotion- based investment decisions.   

How to check your risk tolerance?

The most important thing before you invest is know your risk tolerance. Risk tolerance does not remain same throughout your life and hence it is important to check at regular intervals. Typically, young people have more risk taking appetite as they don’t have much responsibilities compared to a 40-year old man with kids. As a result, young people can invest in high risk investment options that have the potential to earn higher returns but carries higher risk as well. In the past 15 years, equity markets have delivered average returns of 14-15%. However, there are instances where the equity markets have slumped more than 10% in a single day. On the other hand, other investment options such as fixed deposits and gold have managed to give returns of around 8% over the years with relatively less volatility. Hence, the question you should ask yourself is if you can digest such a jump on one particular day. If not, then less volatile investment options will be a better pick for you.

To gain clarity on risk tolerance, you can use online tools that will help you assess your risk tolerating capability. The questions are meant to understand your risks tolerance and attitude towards investing. E.g. one question can be on the action that you are likely to take if the value of a stock where you have invested decreases by Rs.100 in one month. The options may include a) Do nothing, b) Wait a few months to make a decision or c) Sell your stocks immediately. Your risk tolerance can be assessed by the options you choose.

A financial advisor can also help you understand your risk tolerance.

What are the different categories of risk tolerance?

As the risk tolerance varies from person to person, it can broadly divided into 3 categories. These categories are aggressive investor, moderate investor and conservative investor. Aggressive investors can take the highest risk followed by the moderate investor or conservative investor. The investment objective of the different risk tolerant varies from one another. An aggressive investor looks for higher returns and as a result don’t mind the volatility. On the other hand, the investment option for a conservative investor is capital protection and not higher returns. He is happy with low returns as long as the initial investment is safe.

Hence, an aggressive investor can invest in high risk investment options such as equities while a conservative investor can invest in fixed deposits or PPF that gives them a fixed rate of return over a period of time. The risk conservative investor is likely to lose sleep if he invests in equities and hence there will be greater chances of taking a wrong decision. A risk moderate investor could diversify his portfolio equally between high yielding assets and assets that help in capital protection.

Investment horizon and risk tolerance

It should be noted that there is a difference between the risk that you want to take and the risk you should take. You may want to invest in equities for a goal that is a year away. However, it may not be the best investment decision as your initial investment amount may turn negative due to market conditions. High risk investment options give good returns if you stay invested for more than five years while low risk investment options such as FD and RD can be selected for near term goals.

Does the risk tolerance change?

The risk tolerance of a person does not remain the same.  The risk tolerance of a 55-year old who is nearing retirement will be very different from a person who has just started working. It is because your investment objectives evolve and the investment horizon to achieve these goals becomes less. Hence, your portfolio should change accordingly. Diversification can help you to update your portfolio according to your changing risk tolerance level. For example, you can increase your debt allocation or reduce your equity allocation as your risk taking appetite decreases. Keeping updated with your changing risk appetite, can help to achieve your financial goals with ease without worrying about market volatilities.

To summarise, the risk tolerance of a person is as unique their finger prints. The risk tolerance depends on two main factors: age and investment horizon. A person in their 20s whose investment horizon is 15 years away, have a higher risk tolerance. However, a person who is 55 and his investment goal is to save for retirement, his risk tolerance will be lower. A person with high risk tolerance will invest in high yield assets while the conservative investor will invest in a low risk product that safeguards capital.  So before investing in any investment option, it is important to check your risk tolerance so that you can make a sound investment option.

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