No two investors are the same. People grow up with different beliefs, attitudes and values to money, which are influenced by their respective environments and experiences. This means that our appetite (or willingness) for risk often differs from that of others around us. In the personal finance context, an investor's risk appetite will determine his or her approach, and the tools used by him or her for saving and growing money.
Conservative investors prefer to have a measured approach to saving, which means that they search out 'safe' avenues for their money, where there is some amount of assured growth or income. Aggressive investors place a premium on growth of their money, and hence prefer asset classes that might be relatively riskier or volatile, but which offer better potential returns. A medium-risk investor lies somewhere between these two.
One's risk appetite is a function of age, knowledge and experience. Typically, the older one gets, the less risk one prefers, due to enhanced responsibilities, and the need to save for retirement. Similarly, people who are bewildered by the complexities of the market, and do not want to take risks with their hard-earned money, tend to be conservative. Meanwhile, those who have extensive knowledge and experience are willing to stomach extra risk for the chance of higher returns. There is no 'ideal' risk appetite; just determine yours and be comfortable with it.
So how does one's risk appetite affect the financial instruments one chooses? Here's a guide.
Low risk appetite-investors
As mentioned earlier, an individual with low financial risk appetite would not want the returns on his/her money to swing wildly between extremes. Therefore, the idea is to invest in assets that offer stable or assured returns. Some examples of these are:
- Government-issued bonds
- Government savings schemes: These include Public Provident Fund, Post Office Scheme, National Pension Scheme, etc.
- Bank fixed deposits: These offer fixed returns, although the interest rates can be sometimes uncompetitive against rising inflation rates.
- Endowment and Annuity products: Such products offer you guaranteed returns, and are hence ideal for conservative investors.
- Money Market / Liquid Funds: These are mutual funds that invest in very short-term, liquid instruments like treasury bills, commercial paper and certificates of deposit.
Medium risk appetite-investors
Investors who are willing to take some amount of risk, but with adequate capital protection measures, are known as medium-risk investors. Here are some avenues for them:
- Corporate bonds: Corporate bonds and commercial paper issuances with a high credit rating from a third-party agency (like CRISIL, CARE, ICRA, etc.) carry limited risk
- Balanced funds: These invest in both equities and debt, thus giving the investor's money a safety cushion of sorts.
- Debt funds: Debt funds that invest in high-quality debt securities have much lower risk profile than equity investments
- Real estate: While experts have been predicting a correction for a long time now, real estate prices still remain high, to the relief of property owners.
High risk appetite-investors
If your primary goal is to maximise your money's growth potential, and you have the stomach for volatility and risk, the following instruments might be for you.
- Direct equity trading: Buying and selling shares directly on the stock exchange requires some amount of knowledge, and hence, is not for novice investors
- Equity/growth funds: These funds allocate the majority of the investor's money into shares, and therefore, carry relatively higher risk (as well as return potential)
- Sectoral funds: These funds invest in specific sectors, like banking, auto or pharma, and are thus considered more prone to intra-sectoral volatility
- Forex, commodity, and derivative trading: Trading in foreign currencies is rather painstaking, complex and best left to experienced investors. The same applies to trading in commodities (agricultural products or metals) and derivatives.
Determining one's risk appetite is the first step for an individual to decide where to invest his or her money. Mutual funds offer a great way to strike a balance between returns and risk, thanks to advantages like diversification options and professional management of the funds. For more information, check out the recent 'Mutual Funds Sahi Hai' campaign by The Association of Mutual Funds in India (AMFI).
Mutual fund investments are subject to market risks, read all scheme related documents carefully.