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Know Your Risks!
April 21, 2009

It is important to understand the risks of the investments you are considering to invest into. But, it is also crucial to understand your own personal risk appetite.


Author : iFAST Research Team



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How should a person handle risk when it comes to investing? We all know that there are some investments which are riskier than others. At the same time, there are also some people who can handle riskier investments, while some cannot. Thus, it is not only important to understand the risks of the investments you are looking at, but also to understand your personal risk appetite or tolerance, when it comes to investing.

Risk profiling can be conducted for investors who wish to assess their own risk appetite towards investing. Different investors have different risk profiles, and this may change with their age, investment time horizon, financial objectives, or even their appreciation of investing.

For example, an investor at the age of 22 may feel that he is young and can, therefore, assume higher risks. Nevertheless, if the money is meant for his higher education, which is scheduled to done one year later, then taking higher risks will not be a good idea because the investment time horizon is short.

Risk profiling helps investors make better decisions by choosing the products that match their goals and level of risk tolerance. For example, a person with a very low risk appetite, but nevertheless decides to have an equity fund, would find it difficult to see the fund go through ups and downs. He would not be able to make the correct investment decision as he is not emotionally prepared to handle the volatile nature of the fund.

On the other hand, if an investor is considered as having an aggressive risk appetite, is able to take on higher-risk funds and has a suitably long investment time horizon, then he would not be getting enough returns for his money's worth if he invests a considerable portion of his money into a conservative portfolio of bond funds.

Putting Your Knowledge Into Practice

The best way to understand your risk appetite is to get down to investing with your own money. Nothing beats putting your own money on the line and understanding your own reaction as the markets go up and down. The important thing is to understand the products you are investing into and why you reacted the way you did when markets moved up or down.

For instance, you might have thought you are an aggressive investor who can cope with a high level of risk based on the results of the risk profiling test. However, in practice, if you find that you always panic too soon every time the market dips, and get overly euphoric and pump in more money whenever markets are on a roll, then high-risk investments are not so suitable for you because they are likely to cause you to lose money.

Our Risk Rating Methodology

Understanding the underlying products as well as the markets they are invested into is also very important. Information on the markets and financial products such as mutual funds can be found quite easily on the Internet. For example, Fundsupermart.com assigns a simple risk rating to all the funds, ranging from 0 to 10. 0 refers to financial investments with the lowest level of risk, while 10 refers to those with the highest level of risk.

Funds with higher risk ratings of 6 and above will generally be more suitable for more aggressive investors. Conservative investors should be cautious about such funds, unless they are meant to be held as a small proportion of a conservative portfolio.

Measuring Risk In A Simple Manner

If investors are presented with a financial product, the first thing they should ask themselves is what the product invests into. Generally, any product that invests into stocks would involve a high level of risk while those which invest into bonds are less risky. There might be exceptions, but it is a good rule of thumb to use.

Generally, low potential returns correspond to low risk, and high potential returns to higher risk. If an investment product comes packaged as a low-risk product, yet promises a very high rate of return, then investors need to scrutinise the product carefully because this is rarely true in practice. So either the product is over-promising its level of returns, or it is understating the risk exposure which the investors are subjected to.

Thus, to understand an investment's risk, it is important to look at its range of returns. While some financial experts may refer to more complicated concepts such as the standard deviation or Sharpe ratio, a simple way to measure a fund's risk is to find out its potential downside.

For example, a sector fund may have delivered returns of 100% return in the year 2007 (during the Indian market's Bull Run), but it may have dipped by 50% or more during 2008 (due to global financial crisis). In such a case, investors will need to ask themselves whether they can bear to potentially lose 50% of their money in a single year. If they cannot, then sector funds are not for them.
Risk Scale

There Are Choices For Conservative Investors

The more conservative investors may typically keep their money in the banks' savings accounts. But that may often be due to their insufficient knowledge of other investment options, including bond funds.

Few investors have such a conservative risk profile to the extent that they cannot bear any amount of loss at all. If a bond fund's history has shown that it had only lost money in one year out of the past 5 years, and the loss was minimal during that one year, conservative investors can consider investing in such a bond fund for better returns relative to the interest rate earned from the savings accounts.

Conclusion

Therefore, it is very important to understand your personal risk appetite. And the best way to do it is to assess your actual experience in investing. Over time, as your experience in investing deepens, and your investment time horizon, financial objectives, etc. change, you would have a better idea of the level of investment risk you are comfortable with.

It is also important to understand the various risks and returns of the investments, and match them with your personal risk appetite. Once you are able to identify your own risk appetite, and the investment products which suit you, you will be able to sleep comfortably at night, without having to worry about the volatility in the markets.

 


iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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