Investors can be grouped into different categories according to how much variability in their investment return they can stomach. Those with a low-risk tolerance or appetite can only handle a moderate amount of variation, while those with a high appetite gravitate towards investments that bear higher risk.
Your risk tolerance should be a top consideration when picking an investment product. Despite this, many first time investors dive in without stopping to ask themselves how much risk they can manage comfortably. As a result, they end up either making panic decisions because they took on too much risk, or they fail to reach their goals because they took on low yielding investments.
So, how do you determine your risk tolerance? Here are a few factors to consider:
1. Investment horizon and investment objectives
Individuals that have more time before they need to access their invested funds generally have a higher risk tolerance than those who need it sooner. For example, if you have invested to raise funds for your child’s college education and the child still hasn’t started school, you will probably have a higher risk tolerance than someone who had invested for retirement and is about to retire.
The reasoning behind this is that you still have time before your child is ready for college hence you can invest more aggressively. Inversely, the individual about to retire is more interested in preserving his/her capital and will want to keep risk low.
2. Age
While this may vary from individual to individual, younger investors are generally thought to have a higher risk tolerance than older ones. Conventional wisdom suggests that the youth have more time to achieve their investment goals and are therefore more likely to take on higher-risk investments. They also have fewer financial obligations. On the other hand, older investors who have outgrown the brashness of youth have a lower risk tolerance for the most part.
3. Capital available
When evaluating your risk appetite, consider your net worth and how much capital you can spare. People who have more capital at their disposal tend to have a higher risk tolerance than those with smaller amounts to invest.
Presumptively, higher net worth individuals can afford to take on more risk since losses would not impact their lifestyle in the same way it would those with a lower net worth. However, some individuals with little capital have a tendency to drift towards riskier investments, which carry the allure of large, quick profits. Unfortunately, when too much risk is taken with too little capital, the investor may be forced out of a position too early.
4. Level of experience
Experienced traders are more likely to have a higher risk tolerance than novice ones. Those with more familiarity bank on it to avoid the adverse effects of high-risk investments. However, those who are just starting out may prefer to keep risk low while they learn the ropes.
5. Personality
Some people are generally more open to risk than others. Knowing your overall attitude towards risk will help you understand your investment risk profile. If you hate losing money, you will probably be drawn to low-risk investments. Inversely, if you would regret the missed opportunity to earn a high return, you may have a high-risk appetite.
In conclusion, before investing, seek to understand what your risk tolerance is. Having done so, pick assets that match your risk profile so that you get the best possible returns for the risk you are willing to take on. Remember, diversification is ideal for lowering risk and maximizing returns, so diversify your portfolio as much as you can.
If you need help determining your risk tolerance or just want to speak to a financial advisor, contact clientservices@sib.co.ke.