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We continue with our mentorship on investing right. If you missed last week’s edition, read it here. . .
Risk appetite, also called risk tolerance, measures the investor’s willingness and ability to take on a particular risk in an investment.
It is not enough to be aware of the risks associated with any specific investment. What’s more crucial is whether the investor will be willing and able to shoulder that risk. To bring it to our everyday life. When you decide to take any form of transportation, either by air, land or sea, there are specific risks that come with any of the means. What you do is choose the means whose risk level you can tolerate. It is a similar concept in investment. For any given investment risk, two people can have different risk tolerance. One can decide to pursue it, while the other rejects it.
The level of risk you can tolerate could be determined by your personality, age, job security, health, net worth, emergency fund, and the length of your investing horizon. There could be other factors, but these are the most crucial. Based on these factors, you will fall on a risk scale. Let’s use a scale of 1 to 10 to indicate an investor would fall. 1 is someone who doesn’t want any risk, and 10 is the extreme eagerness to take risks.
Risk Averse- An investor who takes a cautious approach to investing- (1-3)
Risk Neutral-An investor who is open to some form of risk and has a more balanced approach to investing. (4-5)
Risk Tolerant- This investor accepts a greater than average risk (6-8)
Risk Seeker- This category refers to an aggressive risk taker (9-10)
It is essential to be aware of your risk tolerance before investing because each category has advantages, disadvantages and the type of investments that fit that profile. For example, a risk-averse person may opt for a low-interest-yielding short-term fixed deposit with a tier 1 bank. In contrast, a risk-neutral person might go for unit trust or mutual funds, and a risk-tolerant investor might go for shares or start a business. A risk-taker might go for digital assets like cryptocurrencies.
Note that this is not cast in stone but remember, the higher the risk, the higher the expected return. The expected return is sometimes different from the actual return. Thus, other things being equal, a higher risk taker will likely earn more interest or reward than a risk-averse person. Here, it’s essential not to be “greedy” chasing high potential returns when you are a risk-averse person. It is also important to mention that investment being low risk does not mean the absence of it. The investment may still go bad! The risk associated with the same asset may change over time or based on the prevailing economic conditions, and it is vital to speak to a licensed investment professional to help you make a choice that suits your risk tolerance profile. Everyone is different; the bottom line is to know your appetite and invest accordingly.
By Desmond Bredu, ACCA, MCSI.
Email: [email protected]
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