Understanding risk tolerance before investing

Before buying a new phone, we give a lot of considerations on the different features of the phone based on performance and utility vis-`a-vis the price. However, very often, we jump into investment products simply by looking at the rate of return offered. There are a host of factors that investors often fail to assess; one of the most important among them all being risk.

Almost all investment products are exposed to various risk, only the degree differs. Under the present market conditions, one thing has become certain, everything comes with a price, including returns on your investments. In order to make high gains, you have to be able to digest high volatility. In other words, a high return generated on your investment is a premium you earn for bearing high risk. This is known as risk-return trade-off.

Before you blindly hawk into financial products, it is important to understand your risk appetite and tolerance level. Most investors make a mistake of using these two terms (risk appetite and risk tolerance) interchangeably. These are two separate concepts that must be analyzed individually before one plunges to make investment decisions. It is important to understand that while the term risk appetite refers to your willingness to take risk, risk tolerance implies your ability to do so. You might love sky diving, bungee jumping and so on but you must also be physically fit to participate in such activities. On similar lines, as an individual you may be a risk-taker, and probably would not hesitate to put your money in risky avenues, but your circumstances hinder you from spreading your investments in risky ventures.

Your risk appetite is backed by a rationale considering risk determinants such as the following:

  • Age: Investors’ risk appetite generally declines with age. This is primarily because as the investor matures in age and reaches retirement, you psychologically cannot tolerate high volatility in your portfolio. On the other hand, as a young investor can comparatively take higher risks as you have a larger number of working years before retirement. You have ample amount of time and opportunities to recover from any possible setbacks in the value of his portfolio. In addition, your risk appetite changes as you go through the various life stages, from being single to marriage and childbearing.
  • Your past experience: if you have a good experience with any product in the past, you tend to become more comfortable with repetitive buying.
  • Knowledge: This is one of those rare assets that may never lose their value. A thorough knowledge about something increases your awareness. Becoming aware of good and bad effects would completely raise your risk appetite.

The following factors will help you to measure your risk tolerance level:

  • Income:Your income is an important determinant to gauge your risk tolerance. If your income is high enough, you will not mind taking higher risks while taking investment decisions and vice-versa. This is because small setbacks in your portfolio will not affect your ability and capability to invest.
  • Financial obligations and expenses: Your spending habits also influence the risk which you can afford to take while investing. Thus although you may be having a high income, if your disposable income is petite you could be refrained from taking high risk. Only if you have enough funds to meet your short term goals, can you expose your portfolio to high volatility.
  • Nearness to goal: The time left for the realization of financial goals also determines your risk appetite. If you are adequately away from meeting a financial goal (in terms of number of years), you can afford to expose your portfolio to higher risk which might enable you to create more wealth in the long term. But if your financial goal is drawing nearer, it would be more prudent for you to be a risk-averse investor to preclude wealth erosion.
  • Emergency fund: Needs to be saved in your bank account or a relatively liquid saving plan like a money market fund, to sustain your present lifestyle for the next 6 -18 months in case you lose your job or for any other financial detrimental emergencies.
  • Life Insurance and health insurance cover: is essential to provide financial security to your dependents in case of any untoward event. This will help your family in paying off your debts and also meeting household expenses.

To learn more about high-returning investments, check out our other blogs.

This article was written by Rose Ellah Ngari, Chief Executive Officer at Vasili Africa. Get in touch with Rose for free investment advice via info@vasiliafrica.com or fill in your details below.


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