Risk vs Reward: Ways to find your risk appetite

Every investor knows that investing in a financial instrument is subject to risk. The level of this risk varies, depending on the asset class and the category under consideration. And yet, investors cannot help but embrace it to chase the possibility of wealth creation, which is the reward for investing in good quality financial instruments. The pivotal question then is - How do you simultaneously create wealth and manage the inherent risks that come along with it?

The secret lies in finding your investment risk appetite - the amount of risk you are willing to take to achieve your investment goals. Here is how you can determine this.

Identify your financial goals

The first step to figuring out your risk appetite is to be aware of why you are investing in the first place. Start by writing down your goals, both the major and the minor ones, and classifying them into negotiable and non-negotiable. Financial goals, like a vacation or a new gadget, can be deferred, but you cannot compromise on goals such as your children’s education and your retirement fund. This classification will help you to fine-tune your financial planning.

Make a note of your investment horizon

Once you have made a note of your goals, assign a timeframe to each of them. It can either be short-term, medium-term, or long-term. You could afford to take a higher level of risk for long-term goals, but maybe more conservative when it comes to short-term goals.

Factor in your age

Age is another major factor that impacts your risk appetite. When you are younger, you can afford to take on a higher level of investment risk because you have a longer investment tenure ahead of you. On the other hand, as you inch closer to retirement, your risk appetite may reduce, making low-risk or fixed income instruments more ideal for you.

Understand your attitude towards risk

Aside from age, goals, and the general investment timeframe, personal opinion about risk is another deciding factor. Some investors, for instance, are inherently open to taking on more risk than others. Taking some time to understand your attitude towards risk can give you more clarity on the level of your risk appetite. The journey to balancing risk and reward doesn’t end here.

To strike the right risk-reward balance, you need to create and manage your investment portfolio according to your risk appetite.

Here are a few measures that can help you do this.

Research your options thoroughly

Given the wide variety of financial products, it is crucial to gauge your options. Research the market behaviour of each investment option to understand the risk associated with them and compare this risk level with the potential reward you can expect.

Aim for a healthy level of diversification

Diversification is an excellent way to reduce risk exposure in your portfolio. Ensure that your portfolio has a healthy mix of long-term investments, insurance, short-term investments, and liquid financial products that come in handy during emergencies.

Focus on asset allocation

Minding your asset allocation, which is how much capital you put into each asset, is a great way to balance risk and reward. If your risk appetite is high, you could afford to allocate a higher percentage of your capital to stocks and other market-linked instruments. But if you prefer lower risk, fixed income options and stable investments must dominate your portfolio.

Rebalance your portfolio periodically

A periodic check-up of your portfolio is a crucial step in maintaining the risk and reward balance because your risk appetite will change over time.

You must ensure that your investment portfolio keeps pace with your changing preferences. Revisit your portfolio each year to keep your asset allocation aligned with your risk appetite.

Summing up

While we all chase rewards, it is vital to assess how much risk you are willing to embrace in the process. By finding your comfort level when it comes to risk, you can select the investment options that make you feel confident and take you closer to your financial goals without making you feel anxious.

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