RISK TOLERANCE – An Integral Part of The Investment Process

Published by Sharekhan Education | January 5, 2021

RISK TOLERANCE – An Integral Part of The Investment Process

Anand, Aamir and Aadrain have been close friends right from school days. They did a lot of things together like most close friends do. They spent most of their time in each other’s company and stood by each other in tough times. All three went to the same college passed the same professional exams and got similar jobs too. But as time flew they got busy in their own lives, got married and settled down; their lifestyles changed, their likes- dislikes changed. One fine day they decided to have a reunion at their favourite café and live those exciting moments again.

Over a cup of café mocha they started discussing their life achievements & financial progress only to find that Anand the bravest of the three was investing in very conservative assets like fixed deposits and debt mutual funds. I have a lot of liabilities and financial obligations so I want my money to be safe. I am not comfortable with the ups and downs of the stock market he said. On the other hand Aamir was looking for higher return avenues and consistently investing in the equity markets. He loved the thrill of the market moves; his portfolio was largely into stocksoptions and futures. While Aadrain had the best of both the worlds he owned a well- balanced portfolio of stocks and bonds.

Risk Tolerance:

Each had a unique style of investing. All three were on different ends of the risk ladder. Anand with a totally risk averse nature was at the bottom of the ladder, he did not like taking risk at all; he’s aim was capital preservation at all costs. While Aamir with his aggressive outlook and willingness to take higher risks for higher returns stood at the top of the risk ladder. Aadrain on the other hand with his moderate outlook to risk stood midway between the two.

One thing that is clear from this story is that each one of the three friends had a portfolio aligned to their individual risk tolerance, the variability of the returns that they could withstand in their portfolios. To achieve financial success it is crucial to match your investments to your risk tolerance. For example if you are an investor who is risk averse then investing completely in equity will do more harm than good to your portfolio.

Knowing your risk tolerance is crucial for your financial success. It depends on two factors your Risk Appetite and Risk Capacity.

Risk appetite means the amount of risk you are willing to take. It is a psychological construct and depends on factors like your age, level of financial education, experience and temperament. On the other hand Risk Capacity is how much risk you can afford to take. It is a financial construct and depends on factors like your income, age, investment objective and time horizon.

How to know Risk Tolerance:

You can know your risk tolerance by completing a risk profiler / questionnaire which will help you identify the optimal level of risk that you can take as an investor; it is an integral part of the investment process. Based on the outcome you could be termed as a conservative, balanced, moderate or an aggressive investor, which in turn will enable you to determine the right asset allocation for your portfolio. This means that if your risk profile is aggressive you will be comfortable with a greater equity exposure in your portfolio but if you happen to be of a conservative risk profile it will limit your equity exposure to the minimum with more inclination towards debt.

A point worth keeping in mind here would be your time horizon to goal. If your time to goal is short meaning less than 3 years then your portfolio should ideally be concentrated towards debt even though your risk profile may be aggressive. This is so that market volatility does not come in the way of you achieving your short term goals. Similarly even a conservative investor can have more of equity, if his goal is long term . Understanding your risk profile helps determine the appropriate equity allocation in your portfolio to achieve specific goals.

Another important point to remember is that your risk profile can change over a period of time. Yes you heard it right. Your risk profile can change with your investing experience. It can change with a change in your perception of risk or change in your income level. Hence it is necessary to periodically review your risk profile especially when you are reviewing your investment portfolio or financial plan.

It would be wise to proceed ahead with your investments only after you know your risk profile.

By enrolling in this stock market course, a learner can learn the basics and the various aspects of trading.

Happy reading and investing….

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