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It’s often easy to tell when a person has ventured into investments that they aren’t cut out for. For example, they may buy stocks because they are impressed by the brands represented, or by those stocks’ past performance. But when the prices of those assets fall, they panic. If they had properly gauged their risk appetite beforehand, they would probably have settled for a safer opportunity, like treasury bills or government bonds. In this article, we’ll walk you through the concept of risk appetite in investing. We will categorise popular investments according to the degree of risk associated with them, and explain how to determine what kinds of assets you should be investing in based on that information.
What is the Relationship Between Risk and Return?
As we’ve noted, a common mistake among newbie investors is that they immediately go for opportunities that promise the highest returns. But this shouldn’t be the only thing they consider. There’s a well-known rule in investing: the higher the risk of an investment, the greater its potential return. Put, investments that can yield the biggest returns (in percentage terms) are also the kind that will most likely cause you financial loss. The converse is true: lower-risk investments tend to produce lower returns. Some assets may generate relatively limited interest payments, but they’re among the safest out there.Low, Medium, and High Risk Investments
Here’s the standard classification of investments based on how risky they are, i.e. the likelihood of your losing money.Low Risk Investments
These are investments with the safest track record. That is, you are unlikely to lose money you invest in them. But they also don’t return hefty percentages. Examples of low-risk investments include government bonds, treasury bills, and fixed deposit accounts with established banks. Naturally, these would be the most preferred options for people with a low risk appetite.Medium Risk Investments
Medium risk investments are propositions with moderate risks attached. They aren’t as safe as low-risk alternatives, but they are less volatile than the highest-risk investments. This category consists of real estate, stocks that pay dividends, corporate bonds, and private equity in a company with a track record of profitability. As you’ve probably guessed, these would be the favourites of people with a moderate risk appetite.Sign up for the Connect Nigeria daily newsletter
High Risk Investments
Assets of this kind can deliver truly impressive returns. But they have the highest chance of wiping out the value of your investments. Cryptocurrencies, growth stocks, penny stocks, options trading, and FOREX are examples. Not surprisingly, many of these are more objects of speculation than they are stable investments. If you can hold your own during the wild price swings of these assets, you may have a high risk appetite.How to Determine Your Risk Appetite
Consider these four things when deciding what degree of investment risk you can stomach:Investment Goal
Think about why you are investing and how much you need to attain your goal. You may want to build wealth for retirement, raise funds for travel or a major purchase, or finance your children’s schooling. Whatever it is, decide whether you can accept not reaching your goal if your investments go sour.Time Horizon
How long do you intend to stay invested, and when would you like to retrieve your money? This could impact your risk tolerance in a number of ways. If you are in your twenties and have about 35 years of wage-paying work ahead of you, it’ll be fine to devote a fair amount of your savings to riskier investments. But as you approach retirement, your focus will shift to preserving wealth, so you’ll camp with safer assets.Financial State
People with a lot of liquidity can afford to dabble in speculative assets. People who don’t have much will suffer more financially if they lose their funds to risky market plays. So they’re better off starting out with safer investments.Personality
Wealth, time, and goals aren’t the only things that make some people risk-averse and others risk-tolerant. Some are hard-wired to detest risk. Others love daring the turbulence of speculative markets. But most people are somewhere on the spectrum stretching between these two ends. If you actually know yourself well enough, you can tell whether you’re a risk taker or the sort of person who values peace of mind above all else.How to Build an Investment Portfolio in Line with Your Risk Appetite
Investment professionals will advise that you create a portfolio that contains a variety of assets. You could have a mix of investments in all three risk levels. But your risk appetite will determine the proportion of funds you allocate to each of them. For example:- If you have a low risk appetite, you could distribute your funds across low, medium, and high risk investments in the ratio 60:30:10 in the corresponding order
- For people with a moderate risk appetite, the spread may be 30:50:20
- If you don’t mind high-risk investments, your holdings may be 20:30:50, favouring riskier opportunities
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Final Words
We hope that this article helps you ascertain your risk appetite. If you find it difficult to place yourself in any of the categories we’ve discussed here, please talk to a personal finance expert. They could work with you to resolve any concerns you have about this.Got a suggestion? Contact us: editor@connectnigeria.com
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