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Assessing appetite for risk
Estimating risk has situational components – crossing the road in traffic might depend on how fast the traffic is moving and how fast you can run, writes Peter Ellen.
March 10, 2013 6:12 by kippreport
One of the factors we (need to) take into account when we look at how we lead our lives is ‘how much risk can I tolerate in order to achieve my goals?’ This question is relevant to whether we accept a job with a high fixed salary, but little chance of a performance-related bonus or one with a lower fixed salary, but a chance of a big bonus; whether we choose a sun-bathing beach holiday or ‘bungee jumping for beginners’’ or whether we cross the road using a footbridge or take our chances in the traffic.
In each of these situations, we make some calculation (not necessarily on a piece of paper) about the rewards associated with a course of action (higher income, more exciting holiday, shorter, faster journey) and the risks we are running (loss of income, personal injury or fatal accident). These calculations are guided by our judgement, based on previous experiences (ours and others’) of the likely success or failure of the different course of action available to us.
Without risk, there is no reward – we know this. Our lives contain an element of risk anyway, some of it out of our control (climate change, financial system collapse etc.) but our choices in life are guided by our judgement the risk-reward equation.
Saving and investing are no different from other activities we undertake. There are no ‘No Risk’ options (i.e. choices that enable you to achieve your goals that carry a guarantee that you won’t lose some or all of your money), but you can find options that run on a scale of low risk to high risk. The first question to ask, of course, is how much risk do you need to run to achieve your goals, and, basically, you can say that the higher the return you require on your money to achieve your goals, the more risk you have to run to achieve it.
However, once this question has been asked and answered, you can say putting your money under your bed will guarantee no gain in value, but the most obvious risk you run is the erosion of value through inflation (and you could be burgled, of course). At the other end of the scale, you could bet your money on a slot machine or a horse, where the rewards are great (you could double your money in a few minutes) but the risk is high (you could lose it all in the same time).
Estimating risk has situational components – crossing the road in the traffic might depend on how fast the traffic is moving and how fast you can run, whether you have done it before, and what you know about traffic accidents. Investment risk is no different.
Ask yourself the following questions…
How much of your money are you prepared to lose (or are able to lose) while searching for higher returns?
Do you think it would be better to put all of your money in one investment (or one type of investment) or spread it over several?
Do you have the right information to make the investment decision?
How do you rate your experience as an investor – expert, experienced, regular, novice or none-at-all?
How do you deal with uncertainty? (Higher risk investments tend to fluctuate in value more than lower risk ones. If you go for a high-risk high-return approach, you may have to tolerate ups and downs).
Most importantly, what sort of person are you? Are you the sort of person who looks for the rush of excitement or do you prefer safety and security?
Understanding risk and your own appetite for risk are key factors in being able to make investment decisions in line with your own personality, values, goals and pocket. If you talk to a financial adviser, he or she will be able to help you draw your own ‘risk profile’ and advise you on the sort of portfolio you should establish to meet your goals within your risk appetite.
It doesn’t matter whether you have $100 or $100,000 to invest, getting the right advice is critical to your financial well-being.
Peter Ellen is Operations Director at Nexus Insurance Brokers www.nexusadvice.com and has extensive experience in the area of sales management and leadership, sales and sales management development and operations management. He has worked in the industry for 28 years in senior management positions and as a consultant, working with regulators, product providers and distributors. To contact Peter for advice with any insurance and investment advice please email him at [email protected]