Risk and returns are inversely correlated, barring rare occasions. Hence, knowing your appetite for risk is essential as your returns profile emerges from your risk profile. Your investments should be guided by the risk profile. A totally risk averse person is very conservative, does not want to losea penny regardless of how little his or her money earns. The compulsive risk taker is at the other end of the spectrum, willing to risk a huge amount of money on a risky bet, hoping to reap a windfall in the process.
Risk tolerance can also be measured by volatility. How much of volatility in an individual’s portfolio is acceptable. Apart from an individual's psychological makeup, various other factors also play a crucial role in determining one's comfort level with risk. Evaluate yourself against the following parameters :
Current income or net worth
If a significant portion of your current and future financial needs can be met by income from non-portfolio sources –like a job or maybe even an inheritance- you can take more risk with your investments. Likewise, higher your current net worth greater is the investing flexibility. In such cases, a portfolio may be geared to achieve capital appreciation through greater risk. When current income is insufficient, investors would want the portfolio to be focused towards generating income and preserving capital, rather than generate capital gains.
Age is a key factor in influencing comfort with risk, given a current income level or net worth. An investor's risk tolerance is expected to increase with income and wealth, but after a point, diminish with age. Check the life cycle investment approach, which uses age as a starting point for determining risk tolerance.
If your investing time frame is longer, you can choose a potentially more rewarding, even if riskier and less liquid investment. That can give you better capital appreciation. If you have a shorter time frame, you are better off with less risk investments, since losses are difficult to recover in a short period of time. For instance, a 30-year old investor has more time to recover from initial portfolio losses than an investor who is 58-years old and is nearing retirement. Hence, as the time horizon shrinks, more importance is attached to how the investments yield returns in the short term than in the longer run.
Your occupation can also shape your risk appetite. A person who is more in his or her occupation, will be emboldened to take more risks without fearing for the future. The converse will be true for someone who is not very secure about his or her future. The nature of the profession too may have a role to play. A businessman for example may feel more comfortable with a higher degree of risk, since his main profession itself involves risk. A salaried employee may on the other hand be accustomed to a smaller degree of risk. There may be a contradiction visible here, that a businessman whose future is not very secure may be willing to take more risk too. This is a fact of life, whatever the occupation profile may be each individual’s psyche will determine his world view of things and in turn, his ability to manage risk.