When it comes to investing, knowing your risk appetite is important. But what exactly is risk appetite? And why is it important to know your risk appetite before planning and managing your investments?
Investments are subject to risk. Risk appetite is nothing but the amount of investment risk you are able to handle. Your returns may not turn out as expected. In a worse case scenario, you may lose some or all of your investment. We know that investing in stocks is more risky than investing in a fixed deposit. Among stocks too, investing in certain types of stocks may be riskier than others.
Now, we will see why it is important to know your risk appetite before investing. Let us say that you have a major proportion of your investments in the equity shares. When the market is going through a downturn, your investment would face a loss in value. In certain cases, your portfolio may be down by thousands or even lakh of rupees in the matter of a few days. At such times, one would need to make wise investment decisions, as pulling out is not always the best option. The question to ask yourself is, are you ready to accept such volatility in your portfolio? Or will this stress you out?
If it does, you should invest in less riskier options. Or do your asset allocation in such a way that your exposure to risky investments is less.
Even when investing in mutual funds, risk appetite is important. Large cap mutual funds are less risky than mid or small cap mutual funds. If you are a risk-averse investor investing in mutual funds, you should ideally start by investing in large cap funds. If you have a high tolerance for risk you may invest in hybrid funds, mid cap funds, sector funds and so on.
Your risk appetite depends on your investment goal. For example, for retirement you will need a large corpus. You will not be able to build such a corpus without taking a given amount of risk. This is because if you invest just in debt instruments your investment will not beat inflation. If your investment goal is something which requires protection of capital and not growth, you can invest in less riskier options.
Your risk appetite also depends on your time horizon. Let us say you are investing for your retirement which is 25 years away. In this case you can tolerate a higher amount of risk. This is because market volatilities even out over a period of time. However, when you are nearing your retirement, you will have less time to recover from market fluctuations. Hence as you near retirement, it is suggested that you move your retirement corpus to debt instruments which are safer.
How do you assess your risk appetite? Ask yourself what would happen if you lost some or all of the money invested. How much can you afford to lose? If you lose the money, how will it affect your personal life and the lives of those who depend on you? As we have seen your risk appetite also depends on your goals and your time horizon.
Understanding the risks of investing and matching your risk appetite to it is essential to get the most out of your investments.