There is trade off of risk and return in every aspect of life. The higher the risk, higher will be the return. Risk plays an important role in taking investment decisions but most of us are unaware of how to determine it. There is difference between risk appetite and risk tolerance. These terms are mostly used interchangeably. Risk appetite means your readiness to take risk and risk tolerance means the ability to do so. For example, you might love racing (which is your risk appetite) but you must be physically fit to do so (which is your risk tolerance). Risk appetite differs from person to person and risk tolerance depends on present financial circumstances and other factors of the individual.
Factors to determine your risk appetite:
1. Age: As your age increases, your risk appetite will reduce. This is generally true for most investors but there are some exceptions where age does not determine the risk appetite, and a person may continue to have a high or low risk appetite throughout his lifetime.
2. Experience: If you have rich experience in particular type of investments, your risk appetite is likely to be higher for such investments. This is so because of the comfort level which sets in with repeated buying. If you have earned higher returns in the past, then you would be interested in taking high risk in such investments.
3. Knowledge: Having deep knowledge and understanding regarding schemes and investments will increase your awareness, which in turn increases your risk appetite. If you are aware about the latest schemes and their working, you will be more compelled to try your luck in it.
Factors to determine your risk tolerance:
1. Income: This is the most important factor in determining your risk tolerance. If your income is quite good, you won’t hesitate to invest in various schemes because a little financial setback will not really affect your financial situation in any way.
2. Expenses: Some people have high income but also high expenses, in this case money left as saving is very little, so there is a fear and doubt in taking decision regarding investment. This implies lower risk tolerance. It is important to cut down your expenses wherever possible in order to keep your financial health intact.
3. Financial Goals: If you are burdened with any short term goals for which you have not planned the financing, then you will not be able to invest much, considering most of what you are earning is spent on such goals. In such case risk tolerance is lower than a situation where your goals are planned and there is no hesitation in investing. Nearness to goals also determines risk tolerance. If your goals are long term in nature, you can expose yourself to higher risk investments, than if your goals are for the short term.
4. Liquid Cash: If you have enough liquid cash accumulated in your account in order to support you for a year or two in case of emergencies, it could be alright for you to make investments. If your lifestyle allows you to take such risk, then the risk tolerance is high.
5. Insurance Cover: Be it any form of insurance cover, if you are sufficiently covered, then you are more willing to take a risk in investments.
In order to take best investment decisions, you should be able to determine your risk appetite and risk tolerance before investing.