What is risk appetite?
Simply put, it’s the amount of risk you can stomach. Broadly defined, it’s your ability to psychologically and financially handle the possibility of negative outcomes.
Now we’ve covered that, how can you figure out your risk appetite?
That depends on two factors: how much money you can afford to lose and your time frame. Losses are no more guaranteed than gains, but it’s vital to consider the worst-case scenario. For organisations, it’s all about time and money. But for, individuals it’s as important to consider temperament.
If you panic at a loss (we all do it) even if you’re still up, your risk appetite is low. If you can handle price swings in a rational manner, your risk appetite is high. But there needs to be a balance between the emotional and financial side. You need to be able to both cope with and afford any drops.
The other important point to consider is the purpose of an investment. Is it a means of growing savings in the long-term? Is it to experiment or gamble on a single asset? Is it to reach a savings goal for a purchase? This is a very personal decision and it can be emotional.
A good way to figure this out is to consider how often you check (or would check) your investments. Checking daily or even multiple times a day can mean you’re more motivated by novelty and excitement. If you’re spending spare change on altcoins out of curiosity, any volatility is part of the fun.
Risk appetite is dependent on our lifestyles and responsibilities. Being close to retirement age, having kids or large amounts of debt tends to equate to low risk appetite.
Investing is always risky. There is always the risk of an institution failing and going bankrupt. Or even the entire country. A change in regulations could affect the value of an asset, as could fluctuating interest or exchange rates.There’s the risk of taking too few risks and missing out on opportunities. No form of investing is guaranteed – even money in a savings account isn’t 100% safe. Systemic risk is universal and unavoidable. And with some assets, volatility is an inherent risk.
That said, investments are on a scale from low to high risk, with the potential returns in proportion to the risk level. Money Market Funds, US Treasury Bills, and Corporate bonds are low-risk, with low returns. Venture capital, IPOs, and ICOs are high-risk, high potential returns.
To summarise, there’s no set way to calculate it, but you should look at certain factors (and consult a financial advisor if relevant):
- Timeframe.
- Financial goals
- Responsibilities/fixed costs
- Your ability to handle the emotional side.
How can you reduce risk?
The typical means of reducing risk is diversification – investing in a range of assets. For example, you might put 90% of your money in low-risk assets and 10% in high-risk, high potential return assets. The worst-case scenario is that the returns from the former category cover any losses in the latter. Best case is that the high-risk assets produce large gains which you would have missed otherwise. A portfolio with this balance is a common choice for medium-term savings. Those with a longer time span can generally take on more risk and expect the returns to even out.