Understand your risk profile

When asked to describe their risk profile, most people would probably describe themselves as risk-averse. After all, who likes to willingly lose money?

When asked whether they are willing to take on risk in exchange for return, we are venturing into the question of risk appetite.

A person with a very low appetite for risk will not be willing to take on risk even in exchange for a return, while a person with a high-risk appetite would be more easily persuaded. In reality, there is of course a continuum of risk and return with varying degrees of shades in between.

There is another dimension to risk, and that is the capacity to take on risk. This capacity can be be linked to the person’s financial situation and goals. A young person with a high income with no dependent and no immediate need for money can be described as having a high capacity to take on risk, while an old person with no income and no insurance coverage can be described as having a low capacity to take on risk.

As seen, everyone’s circumstances and situation are different. That is why adopting some commonly accepted rules of thumb as wisdom can be dangerous, as what works for one may not work for another.

For instance, if an old person who realizes he has been too prudent financially in his younger days is suddenly in a hurry to grow the retirement portfolio that he relies on, he may need to be advised to temper his risk appetite and if need be, reduce his risk exposure. On the other hand, if a young person with a high capacity to take on risk is restricting his universe of investment products to merely a safe and secure investment, then he can be educated to expand the universe of investment products under consideration. If a person with a low capacity to take risks wants to move to a position with a high capacity to take risk, he can consider earning more and spending less for a start.

The diagram below lays out the four quadrants of possibilities.

Knowing where one lies in the four quadrants is a good start. Financial education, which encompasses investment knowledge, risk management, and basic budgeting and insurance knowledge, is the crucial next step. Having a framework and an appreciation of the four quadrants can help one achieve better clarity on one’s current position. It can also help an individual consider alternatives and evaluate any advice given, as nobody understands the situation as well as ourselves.

“An investment in knowledge pays the best interest.”

Benjamin Franklin