Investors and finance enthusiasts have often been confused by terms like ‘risk tolerance’ and ‘risk appetite’ and their implication on decisions pertaining to investment. To understand the meaning of ‘risk tolerance’, let’s take a simple example of driving a car. An individual while driving on a highway has a perception of speed that he/she should maintain. For some individuals who consider highways for fast driving, prefer a speed of 140 km/hour whereas those who consider fast driving on highway could be dangerous, they prefer a speed of 60 km/hour. And yet there are those individuals, who prefer a moderate speed of 80-90 km/hour as that would balance between speed and safety, both.
Based on these likeliness and comfort levels with respect to speed, the above preferences can be categorized into conservative, moderate and aggressive. Similarly, in investments it is very important to analyze one’s risk tolerance based on the returns an investor expects and their risk appetite- their ability to digest losses in a case of market failure.
Now the question is – How to plan our investments based on our risk tolerance? There are several factors to consider depending on the needs of the investor. Some of them are mentioned below –
1. Time Horizon
Investments need to be considered looking at the time horizon of the investments. For example, if the time period for a prospective investment is less than 12 months, then for a conservative investor it would be wise not to invest in such equity market. Not only such equity markets are volatile, it also bears higher risk of capital loss. Therefore, a conservative investor should invest only in debt funds (money markets) where the risk is minimal and returns are both minimal but safe. A moderate investor can use some aggressive debt funds like Income funds, Long term debt funds to ensure some higher returns as compared to just investing in money markets, whereas an aggressive investor may add some flavor of equity markets in their investments to capitalize on the markets gain.
2. Financial State
Investments need to be considered looking at the time horizon of the investments. For example, if the time period for a prospective investment is less than 12 months, then for a conservative investor it would be wise not to invest in such equity market. Not only such equity markets are volatile, it also bears higher risk of capital loss. Therefore, a conservative investor should invest only in debt funds (money markets) where the risk is minimal and returns are both minimal but safe. A moderate investor can use some aggressive debt funds like Income funds, Long term debt funds to ensure some higher returns as compared to just investing in money markets, whereas an aggressive investor may add some flavor of equity markets in their investments to capitalize on the markets gain.
3. Investment Diversification
Investments intended for our future requirements must be well-diversified irrespective of an individual’s ‘risk appetite’. For example, for an aggressive investor, investing in a set of equity funds is equal exposure to loss and gain. To alleviate chances of loss, wealth management advisors would always suggest diversification of individual’s investment portfolio. While the portfolio may contain higher volume towards equity investments, other asset classes can be equally accommodated to experience better gain.
4. Ability to Withstand Tough Markets
Risk tolerance is based on psychological factors which may influence an aggressive investor to convert a conservative one and therefore change their investments. Such conversions are natural when risk assessments are not conducted efficiently. An individual with an appetite for high risk tolerance should understand market adversities and learn how to hold on to investments in difficult situations.
