Investing in Mutual funds: Determining Your Risk Level
There are a lot of 'Risk Tolerance' measures out there that ask you questions, and tell you your Risk Profile. Most of us have a good sense of the kind of risk we can stomach so we don't really need a test to tell us that.
What you might not be aware of, however, is that your life situation might demand that you take on specific levels of risk, no matter what your risk appetite might be. It is not a matter of what kind of risks you want to take, it's a matter of what kind of risks you can take given the circumstances that you are in.
Following are some parameters prescribed by Fundsupermart.com for determining the amount of risk you can take given your life situation.
1. Time Horizon (or Age) :
The longer your time horizon (or, the younger you are), the more risk you can take. The more time you have, the more you are able to ride out market cycles and volatility, so that you never sell at a loss, but always at a profit. Also, the power of compounding increases the worth of your portfolio dramatically with time.
Conversely, the less time you have (or, older you are), the less risk you can take. If you are close to retirement, it is best that you invest your money in stable, conservative mutual funds. This is because you don't want to be caught in a down market cycle when you need your money. You would have to sell at a loss.
2. Risk Transition
As your investment horizon approaches, you have to scale down the level of risks which you take in your investments. For example, you might have bought high risk, high returns mutual funds for your retirement 20 years ago. In 15 years time, it is wise to scale down to medium risk products and then low risk products in 18 years time. This way you preserve the gains you have gotten in the early years.
If you have at least 4 - 6 months worth of living expenses tucked away, you are more able to invest in high risk mutual funds. In case of any emergency, you would have sufficient cash to tide you through, and you do not need to liquidate your investments.
If you do not have this amount in cash but would still like to invest, it's best to keep your investments to low risk mutual funds. In case you need to redeem it, you are less likely to be caught with high losses.
4. Lifestyle needs
Take a good look at your lifestyle requirements. How do you imagine yourself retiring? Or what is the goal for which you are investing?
Do not invest in high risk products simply because everybody else is doing it. Determine what you need and invest accordingly.
Generally, there is a good correlation between risks and returns. The higher the risks, the higher the returns are likely to be. However, the key word here is 'likely'. There is no guarantee. High risks instruments can sometimes crash, and lead to large losses.
So you have to be very mindful of whether your life situation allows you to handle such a crash. If not, it is better to choose less risk products.
Next : Picking the right fund