This article outlines different degrees of risk tolerance investors have, and suitable investment options
Investors often hear of the maxim, 'greater the risk, greater the reward'. Risk tolerance is the level of comfort with which a person takes risk. What exactly is this risk and how does it effect an investor's decision?
Risk appetite can be defined as the willingness of an investor to bear risk.
Investors despise uncertainty. Risk appetite, risk aversion and risk premium is often used in place of the other. However, there are some finer nuances that distinguish one from the other.
A) Risk appetite - Some people take higher risks. In other words, they are willing to lose more until they get the expected returns. A person who can stand all his money getting eroded has a greater risk appetite.
B) Risk-averse - Reluctance to accept. Risk-averse persons exhibit reluctance to accept a bargain with an uncertain payoff. He would instead be content with a deal that is more certain, but possibly with lower-than-anticipated returns. An investor is said to be risk-averse if he prefers less risk to more risk
In between the two behaviors of risk aversion and risk seeking is a state called risk neutrality. One who is indifferent to risk is risk neutral.
C) Risk premium - Risk premium is the return in excess of the risk free rate of return that an investment is expected to yield. It can be construed as the reward for holding a risky investment rather than a risk-free one.
An investor's appetite for risk decreases with age. A young unmarried investor may be quite aggressive. This is simply because he has not much financial commitment and has many more working years ahead of him. Even if he loses he can earn more.
On the other hand, an investor in his retirement years has to be more cautious. He cannot take high risk because he is dependent on the returns. He cannot afford to lose his investments. His need for money is far greater with inflation and day-to-day expenses. A middle-aged man will invest mostly in equity, while judiciously setting aside some funds for fixed instruments and retirement savings.
An investor must first understand his risk appetite. Once he comprehends it, he must invest in instruments accordingly.
Take for instance the balanced funds, offered by many fund houses. Aimed at such investors, they have a balanced mix of both high risk and low risk instruments.
Investors often hear of the maxim, 'greater the risk, greater the reward'. Risk tolerance is the level of comfort with which a person takes risk. What exactly is this risk and how does it effect an investor's decision?
Risk appetite can be defined as the willingness of an investor to bear risk.
Investors despise uncertainty. Risk appetite, risk aversion and risk premium is often used in place of the other. However, there are some finer nuances that distinguish one from the other.
A) Risk appetite - Some people take higher risks. In other words, they are willing to lose more until they get the expected returns. A person who can stand all his money getting eroded has a greater risk appetite.
B) Risk-averse - Reluctance to accept. Risk-averse persons exhibit reluctance to accept a bargain with an uncertain payoff. He would instead be content with a deal that is more certain, but possibly with lower-than-anticipated returns. An investor is said to be risk-averse if he prefers less risk to more risk
In between the two behaviors of risk aversion and risk seeking is a state called risk neutrality. One who is indifferent to risk is risk neutral.
C) Risk premium - Risk premium is the return in excess of the risk free rate of return that an investment is expected to yield. It can be construed as the reward for holding a risky investment rather than a risk-free one.
An investor's appetite for risk decreases with age. A young unmarried investor may be quite aggressive. This is simply because he has not much financial commitment and has many more working years ahead of him. Even if he loses he can earn more.
On the other hand, an investor in his retirement years has to be more cautious. He cannot take high risk because he is dependent on the returns. He cannot afford to lose his investments. His need for money is far greater with inflation and day-to-day expenses. A middle-aged man will invest mostly in equity, while judiciously setting aside some funds for fixed instruments and retirement savings.
An investor must first understand his risk appetite. Once he comprehends it, he must invest in instruments accordingly.
- A high-risk investor has mostly equity instruments in his portfolio.
- A low-risk investor concentrates on fixed income sources.
- In the middle path are investors with medium-risk tolerance. They can have a mix of equity and debt in their portfolio.
Take for instance the balanced funds, offered by many fund houses. Aimed at such investors, they have a balanced mix of both high risk and low risk instruments.
