A quick guide to understand your risk profile

October 4, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

“Risk is a part of God’s game, alike for men and nations” – Warren Buffett

It is a known fact that practically all investments have a certain degree of risk. But the irony is that though we are aware of this, most of us aren’t really clear about what exactly this risk means and how do we go about measuring our own risk-taking ability. Here is a quick guide on what exactly risk means and how to determine your risk appetite.

The term ‘risk’ indicates the variability of rate of return, or the amount by which the investment outcome deviates from its expected value. If this sounds too technical, here is a simpler explanation. Risk is the possibility of your money increasing or decreasing in value from your expectations of the investment. So wider the range of possible outcomes, the greater is the risk you experience.

– Time Horizon and Investment Goal
A long-term investment will let you withstand the ups and downs of the markets and handle more risk in comparison to a short-term investment. Thus, if you have short-term or immediate financial goals, for which you park money in a short-term investment, your risk-taking ability reduces considerably.

– Surplus Cash Position
If, after making investments towards all mandatory obligations, you are left with a further surplus cash, you sure do have a better risk-taking appetite. Such surplus cash acts as a buffer to hold on to, in case you experience any loss.

– Age
The younger you are, the greater is your risk-taking ability. As you grow older, family commitments increase thus reducing your ability to take risk.

Making investments without a clear understanding of your risk is like heading on a road trip without a map.

– The Conservative Investor
If you are one of those people who want their money to grow yet do not want to expose the principal amount to any risk, then you are a conservative investor. You would ideally choose financial products that do not fluctuate much in value. What you must keep in mind is that as a conservative investor though you have the peace of mind, you sure do miss out on the growth opportunities in times of an upward trend in the economy.

– The Moderate Investor
As a moderate investor, you would want your investment to grow significantly and thus tolerate a certain amount of volatility in the market. Your portfolio is diversified across sectors with investments in a few safe bonds and a few blue-chip stocks. This approach may not fetch you very high returns when the market goes up, but it sure will not fall much in bad times.

– The Aggressive Investor
As an aggressive investor, you only look out for growth of your money. Of course, in good times, you would make a considerable amount on your portfolio, but you also stand to lose it all during a downfall.

A few guidelines across 4 different life cycles to help you save and make appropriate investments.

Stage 1: Early Earning Years
Net worth is less and so are the responsibilities. This is the best stage to accept higher risk and earn higher returns. Equity and equity-oriented funds are a good bet.

Stage 2: Mid Career
Decent accumulation of wealth would have already happened by his stage. At the peak of responsibilities, this is the stage at which you must have certain tangible investments and adequate insurance. Moderate to high risk investments, with an investment horizon of 10 to 15 years would prove beneficial.

Stage 3: Late Career
Reduce your investment horizon as most of your family commitments would be nearing their end. Preservation of capital is vital at this stage and hence, reduce risk considerably.

Stage 4: Retirement
At this stage, investments become a vital part of income. Preservation of wealth is mandatory for medical emergencies and other such expenses. Thus, opt for low-risk low-return investments that could be easily liquidated.

(Write to the author at deepak@myinsuranceclub.com)

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