What is your Risk Appetite?
What is my Risk Appetite?
We all have aspirations of making sky-high returns on investments. However, in practicality that may not be feasible. What should really be on investors’ minds is their respective risk appetites – what they are willing to invest given their financial situation and aspirations. Risk can come in many forms – inflation, volatility, interest rate or default – therefore it is of upmost importance that you know what your own threshold is, before you make any investment decisions.
First of all, it is best to distinguish between risk appetite and risk tolerance, as these are often confused terms. Risk appetite depicts your willingness to accept risk, while risk tolerance means your ability to do so. These should both be determined before you decide to invest your money, as they dictate the distribution of your assets. This article should hopefully provide some insight into what investments are right for you.
The first element to consider is your risk tolerance. The primary contributors to tolerance are income and expenses, as these dictate how much you can afford to contribute to a plan, or lose on investments. A key component of investing should be creating a cash flow budget, to see how much you spend in a month or year (as is recommended for all aspects of financial planning) – this then allows you to see how much you can realistically afford to put aside a month for a portfolio. Indeed, it is advised that when considering risk tolerance, you also maintain a liquid cash reserve that may cover 12 to 18 months of your current lifestyle, just in case. Your financial responsibilities also play into your risk tolerance – are there any goals you wish to achieve in the future, such as paying for your child’s education?
On the other hand, risk appetite measures the degree of variability in investment returns that an investor is willing to withstand. Indeed, tolerance plays a major part in this variable – if you are unable to stomach large fluctuations in your portfolio, you may act impulsively or let your emotion crowd your judgement. This could very easily lead to below-average returns.
The second aspect that one should consider is their investment goal; what it is you are investing for. This may be for future children, a pension scheme, or just for wealth creation with no goal in mind – either way, this has an impact on what investments you should consider. For example, a pensions scheme should probably be a more conservative approach, investing in safer assets that see little fluctuation. Finally, the investment time frame is important. Risk appetite is liable to change over time; as we get older and retire, our focus shifts more to long term financial security.
Risk appetite may then be classified into three distinct classes – aggressive, moderate and conservative. Those who have an aggressive investing strategy are typically looking for high gains, alongside high risk. However, they tend to be market savvy and have a deep understanding of the market – many casual investors may not be as prone to this level of risk with their own finances. As a general guide, these investors may invest up to 70% of their assets into equities (and other high-risk assets), with the rest in safer vehicles such as bonds.
‘Moderate’ investors take a more balanced approach, whereby they accept some risk, but may wish to achieve reliable growth over a 10 to 15-year time horizon. A conservative investment strategy is the most prudent, where investors are willing to accept little to no volatility on their savings. These are usually the most diversified and hedged portfolios, which can offer reliable returns if managed correctly, but may not achieve the highs that aggressive investors can potentially reach.
Deciding to put away any money into investments depends a great deal on your financial situation and outlook. However, perhaps the only person more qualified to determining your investment
strategy than yourself is an independent financial advisor. Your long term financial security, and perhaps your comfort in retirement, can be maximised by speaking to someone qualified.