While discussing financial issues we tend to use the two terms, Risk & Return mostly together. This is because we need to base all financial decisions on balancing Risk and Return. While we understand and measure return easily, we tend to presume the understanding of Risk without making much effort towards measuring it. Further we also tend to favorably believe, that by opting for a high-risk investment, we can assure ourselves of higher returns. Risk evaluation relates to both the investor and the instrument of investment, and therefore it would be appropriate to understand the concept in some more detail.
Instrument Related Risk
In financial terms Risk is relates to the volatility of the instrument. The risk is both upside and downside along with the associated probabilities. With some mathematical calculations, we can measure risk and suitably convert it into ranges in which the movement can take place. We would be concerned more with the downside Risk. Each instrument has its unique risk characteristics. And one should broadly be aware of the risks which accompany a particular Asset Class.
In the Financial Market the risk is lowest in Risk free instruments ie Govt Securities/PFs/Savings/FDs/Cash. It slightly increases in case of Debt instruments and is greater in Equities/Derivates. The risk within a particular Asset class is further varied for different sub Asset classes. You should participate in a particular Asset Class with only that much amount of capital for which the associated downward risk is acceptable. As a thumb rule the investment in equities should be generally in the proportion of (100-Age) % of net worth. Further we should always keep the money required for next five years in debt instruments. And residential house may not be counted towards net worth for the purpose.
Investor Related Risk
There are two dimensions of Risk which should be understood for measuring risk. One is the Risk appetite and other the Risk Capacity.
(a) Risk Appetite. This is a personality and aptitude related characteristic and can be broadly measured using psychometry tests. However, the tests are not very accurate. The past financial behavior of the investor needs to be integrated in arriving at appropriate risk behavior. Being cautious in financial matters is not a sign of weakness and being aggressive is not necessarily a virtue. The assessment may indicate the nature of asset classes which one can participate in, and which ones should be avoided. As a thumb rule, if you don’t know how much you might lose, don’t get into that investment. Even if on has high risk appetite, the investments should be within the risk capacity.
(b) Risk Capacity. This aspect pertains to the financial capability of the investor. Which in turn would depend on various factors like Income levels, Nature of Job Security, assets and Liabilities. Further, age is a relevant factor here, because the capacity to take risk of a young person is higher as compared to a person nearing retirement. The assumption being that the younger person has more time to make up for losses if any. Whereas an older person might not get the chance to recover from losses. However, the context of age should also be evaluated in conjunction with the net worth of the individual and retirement security. More often, one may find that the risk capacity might actually go up with age. The assessment may indicate the asset allocation, or in simple words the amount of capital than can be invested in different Asset Classes.
Conclusion
It is possible that someone with high risk appetite might lack in capacity and vice versa. One needs to periodically review own Risk capacity and revise Asset Allocation. Measuring risk is important. The probable as well as maximum downside of each investment should be ascertained and considered before making the investment. A balanced portfolio should have the aggregate risk, within the Risk Capacity of the individual and aligned to his/her Risk Appetite.