By Unit Trust Corporation
People often confuse the use of the terms savings and investments. Savings is money set aside for emergencies or to meet very short term goals, whereas investment is when money is placed in financial products with the objective of earning returns over time.
Another significant difference between the two is the risk they bear and the returns they offer. The main objective of savings should be safety and ease of access to money. It is therefore held in low risk products such as bank accounts which generally provide a lower rate of return. On the other hand, money invested in various products like stocks, bonds and some mutual funds is subject to fluctuations, where the value of the money could increase or decrease over time.
When investing your money how much risk should you take? In 2008, when major financial markets lost more than 30% of their value, would you have been able to tolerate this level of losses on your investments?
Risk Tolerance measures how comfortably one handles declines in the value of their investments, both emotionally and financially. Let us consider the engaging relationship between a cat, a mouse and cheese. The mouse will gauge its ability and willingness to attain the cheese, and then choose the most appropriate route, considering the cat’s presence. To make a profit, there are some risks you would have to accept, as would the mouse in the pursuit of the cheese. A major question is how much risk should you take? Or in the analogy of the mouse, which route should I take to attain my objective of the cheese. This question is best answered by determining your risk tolerance as it provides a realistic understanding of your ability and willingness to tolerate large swings in the value of your investments.
How to determine Risk Tolerance
There two main components when determining your risk tolerance; the first is your ability to accept risk and the second is your willingness to accept risk. Your ability to accept risk would be determined by factors such as age, the time you have to achieve the goal and your net worth. Your willingness to accept risk would however be driven by your personality and investment experience.
When do you need the money?
One way of determining your risk tolerance is knowing how soon you expect to need the money you are investing, this is called your time horizon. Based on your goal, if you need the money you have invested in a month’s time, then you want to invest far more conservatively than if you need the money in the next 30 years. So you need to pick a portfolio that fits your needs, it is risky to pick a heavily stock oriented portfolio if you will need the money within months. While there is the likelihood of a growth in your portfolio over the period, there is also the likelihood of a loss which could derail you from meeting your objective.
What is your net worth?
Net worth is simply your assets minus your liabilities. Risk capital is money available to invest or trade that will not affect your lifestyle if lost. Therefore, an investor with a high net worth generally has more risk capital and can assume more risk. It does not mean that he is willing to accept a high level of risk but the ability to accept it is present.
Unfortunately, those with little to no net worth or with limited risk capital are often drawn to riskier investments in the hopes of generating higher profits. If the risk of loss materializes they could lose everything. It is therefore important to invest within your risk tolerance.
What are your Investment goals?
Your investment goals must also be considered when calculating how much risk can be assumed. If you are investing for an important goal such as your child's college education or your retirement, how much risk do you really want to take with those funds? Conversely, more risk could be taken if you are using true risk capital to attempt to earn extra income.
Are you new to investing or experienced?
Your level of experience is another essential factor when understanding your risk tolerance. A new investor tends to be very observant and cautious while experienced investors would be more comfortable committing more capital to an investment. Even if you have the guidance of an advisor, it’s important to understand exactly what you’re putting your money into as well as all the risks involved.
What is your attitude to risk?
Your personal tolerance to risk is a major determinant in shaping your investment strategy and portfolio structure. A cautious person may develop a conservative approach to investing, hence will have a lower tolerance to risk and intuitively a lower expectation of return. The opposite would be true of an entrepreneurial investor who would have a more speculative, higher risk investment portfolio.
Knowing your risk tolerance goes far beyond being able to sleep at night or stressing over your funds. It is about analyzing your personal financial situation and balancing it against your goals and objectives. Ultimately, knowing your risk tolerance – and keeping to investments that fit within it – will enhance your financial well-being.