Any investment has two concepts – Risk and Return. If you take more Risk, your investment can get more Return. However, more risk can also mean getting a negative return also, if the time-frame is too short. This is why every investor, irrespective of their maturity, knowledge and experience level, needs to know how much risk they are comfortable with.
What does taking risk mean? Financial experts will tell you that risk tolerance is the degree of variability/swings in investment returns that an investor is willing to withstand. Simplifying it, this means if you wanted 10% return and got 5% return – how comfortable would you be with it?
Let’s look at another instance. You set out with an assumption of 15% annual return, but you get 5% negative return. Will you be comfortable?
It is critical that you have a realistic understanding of your ability and willingness to bear the risk. The ability to tolerate large swings in the value of your investments will tell you how comfortable you really are. It is important, to be frank, and honest with your fears and worries.
You may tell people that you are very risk-taking, but a small swing in investment return may surprise you negatively. If this trend keeps on happening, it is important that you accept that your perception about yourself is not correct.
As a thumb-rule, higher returns come when you take higher risk. If you take smaller risks, returns should not fluctuate much.
- If you take on too much risk, you might panic and sell at the wrong time. This may defeat the entire purpose of your investments.
- If you take on too less risk, you may never reach your desired financial goal in time. This will, also, defeat the entire purpose of your investments.