Understanding One’s Risk Appetite While Investing

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In the dynamic and volatile world of trading, there is no such thing as a “free lunch”. Everything comes for a price, especially the return on investments. In order to earn higher returns, a trader has to be able to digest higher risk.

Different financial instruments have different risk-reward ratios. For example, a fixed deposit is a safe bet but the returns are also considerably low. At the other end of the spectrum, investments in derivative instruments like futures and options are highly leveraged and they can give high returns. But they also carry the risk of high losses.

That is why, a trader needs to determine and measure ones risk appetite carefully before any investment in order to avoid heavy losses that are beyond his or her capacity to bear. If a trader’s risk tolerance level is low, he might run the risk of losing the entire amount he has invested, or even more.

Risk appetite can be defined as a gauge of how “risk hungry traders are”, that is, how much a trader is willing to invest in order to gain profit, at the risk of losing the whole amount. Although risk plays a crucial role in investment decisions, not many people are aware of how to determine this.

A trader might be comfortable navigating the market’s highs and lows or he might find the uncertainty that comes with an aggressive investments strategy too stressful. Weighing out a few factors can help the trader determine whether he is more inclined towards the former or the latter.

The key factors that need to be considered in determining one’s risk appetite are-

Age- Risk appetite usually reduces with age. A trader who is nearing his retirement would rather focus on securing his retirement corpus rather than take huge risks. On the other hand, a young trader will want to invest in equities and higher risk investments, because he will have sufficient time to recoup his losses if the need arises.

Knowledge or Experience- An experienced trader usually has a higher risk appetite because he is adept at his game and understands the field. But a novice who has just started trading would think twice before investing in risky ventures. Normally, a trader should wait until he masters the tricks of the trade before investing in higher yielding and potentially more volatile assets.

Expenses- When it comes to trading, one can never rule out the question of money. Even if one’s income is high, he may have a lot of liabilities and expenses weighing him down. Such an investor will usually have a lower risk appetite because there is doubt and uncertainty in his mind and the fear of losing money.

Past experience- The traders who have earned substantially high returns from previous ventures would naturally have a high risk appetite and more confidence while investing. They will often be comfortable with repetitive buying.

After considering these factors and determining one’s risk appetite, a trader needs to take a decision accordingly. If one cannot afford to lose the entire amount he is investing, he should also not keep the expectation of earning huge returns. As the saying goes, “greater the reward, greater the risk.”