Know your risk tolerance before buying financial assets

In the world of finance, you often get to hear about ‘risk tolerance’ or ‘risk appetite’. These words are usually used while referring to the investors and are correlated with the level of risk inherent in an asset class. For example, one often hears that ‘equity’ is one of the riskiest asset classes, while debt and gold are among the asset classes that carry the lowest risk. Therefore, the level of risk that an individual is ready and willing to expose himself by investing in asset classes carrying varying degrees of risks is the risk tolerance level or the risk appetite of the individual investor.

The level of risk inherent in the asset class is the product risk, while the level of risk that an individual investor can take is the risk tolerance level of the individual investor. The product risk is determined by the risk-reward ratio of the particular asset, so the higher the risk, higher would be the reward. Equity being the highest risk asset as the possibility of loss of capital in high due to extreme market volatility, equity investors reap the highest reward over the long term. On the other hand, the risk of capital loss in the case of bank fixed deposit is quite low, hence the returns on FDs are among the lowest.

The risk tolerance level of one individual can be quite different from another. This is because there are several factors that determine the risk-taking capacity of individuals. The risk tolerance level of an individual depends on the person’s income level, age, financial behaviour, emotional quotient, cultural background, etc. Hence, higher the income level of an individual, higher will be the level of risk tolerance. However, higher the age of an individual, lower will be the risk tolerance level as the financial responsibilities and liabilities are higher for a person in his 50s than an individual in his 20s.

So, once a person knows his risk-bearing capacity, he can decide on which of the asset classes to invest and in what proportion. The higher the risk tolerance level of an individual, the more the propensity to invest in risk assets such as equity, and the lower the risk tolerance level, the higher the propensity to invest in low risk assets such as debt. A diversified portfolio consisting of equity, debt, gold and real estate can counterbalance the risk of high risk asset with low risk asset, hence right portfolio allocation assumes importance in mitigating risks.