What is Your Risk Appetite?
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There are an endless amount of investment vehicles and assets available to investors today and it can be difficult to pick the ones that best suit your needs. If you are considering investing for the first time then the first thing you need to do is assess your risk appetite. Once you have managed this, you are ready to do some research and put together your own portfolio of investments.
What is risk appetite?
Also known as risk tolerance, risk appetite refers to your desire and ability to take on financial risk. The financial markets are in constant flux and risk is essential for profits and losses to be made. Risk can be measured in terms of the likelihood of the risk occurring and also its impact. The general rule of thumb is the higher the risk you take on, the greater the potential reward.
How much risk should I take on?
To answer this question, you will need to look at more than just your personal attitude to risk. The most important factor is your personal circumstances, in particular your proximity to retirement.
If you are nearing retirement then you should hold mainly low risk investments to ensure that you don’t lose money that you may need when you stop working. If you are holding a high risk asset that is performing poorly then you may not have much time to try and recoup these losses.
If you are further from retirement, or you have money free to invest, it would be wise to use your capital for higher risk investments. This is because you have the chance of realizing a greater profit and more time to recoup any losses before reaching retirement age.
The nature of financial markets means that they constantly fluctuate – a successful investor will assess the risk and use these fluctuations to their advantage. Professional asset managers will use risk models such as those provided by http://www.sungard.com/apt/ to asses the risk attaching to their portfolios.
High risk investments
Investors holding a portfolio made up of predominantly high risk investments are known as aggressive investors. High risk investments include:
- Stocks and shares – you can lessen the risk by sticking to shares in well-established companies with a proven track record. Companies in some industries (for example biotechnology) are much higher risk investments and should be approached with care.
- Investments in less stable countries. Many factors can affect the risk attached to investing in a given country, particularly war and political instability.
Low risk investments
Investors holding mainly low risk investments are know as conservative investors. Some examples of low risk investments are as follows:
- Bonds – especially government bonds, which are lower risk than bonds issued by a company as there is less chance of a government defaulting and failing to repay the debt. Of course for those unfortunate investors holding Greek government bonds, they didn’t turn out to be such a secure investment!
- Balanced mutual fund – your money will be pooled with that of other investors and invested in a mix of stocks, bonds and cash.
Diversification
A diverse portfolio is one containing assets with different risks attaching to them. If, for example, you live in the USA and all of your investments are based in the UK, a change in the dollar/pound interest rate could effectively wipe out all of your profits. For this reason a wise investor will diversify his or her investment portfolio across different asset classes and geographies. This means that one adverse event will not have a devastating affect your entire portfolio. The aim is for your other investments to mitigate any loss and allow you to realize a profit.
Portfolio optimization
It is important to regularly review your assets and ensure that your risk exposure still meets your risk appetite – this is known as portfolio optimization. Professional asset managers use advanced portfolio technologies to help them to manage and optimize their portfolios, click here to find out more.
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I am pretty high risk, but thankfully diversified enough to stomach potential losses here and there.
I would say that my risk appetite would be pretty low. I have been looking at investing in P2P loans though. I haven’t invested any money yet but being able to spread the risk across hundreds of loans is very appealing to me.
I have never done P2P, but am about to owner finance part of the sale of my business. It should be a good investment.
I think Joe has a good point. There is no “one size fits all” optimized risk. It has to be in line with each individual’s goal.
I agree. Everyone certainly has their own standard for risks and goals.
Good points, but I think true portfolio optimization happens when your risk exactly matches the goal you’re trying to achieve. Once you know how much risk you need to take, then it’s easy to historically eliminate most investments and create a congruent portfolio.
What if your stomach for risk is lower than what it would take to reach your goal?
Play the lottery? No, I think if you don’t want to invest in anything that carries risk, you have to save that much more or work for a longer amount of time. I guess it would depend on your goal.
It would be nice to have an exact goal in mind. I know generally what I want to achieve, but coming up with a number seems to be a bit harder.