How to Balance Risk vs Rewards in investment?
January 28th, 2010 by ALVIN SOONG
Here are three factors you should consider before investing:
1 Willingness to take risk or risk tolerance -
It is the amount of risk you are comfortable taking, or the degree of uncertainty you can handle. For example, if you can sleep soundly even when your investments are experiencing dramatic swings in value, you are considered risk-tolerant. Risk tolerance often varies with age, income and financial goals. Financial institutions in Singapore typically measure risk tolerance using a profiling questionnaire.
2 How much risk you can take
Besides measuring your risk tolerance, you also need to know how much risk you need to take to achieve your financial objectives. It is a useful indicator because you may realise that you do not really need to take the risk of investing in that product after all. The need to take risk - called risk capacity - is based on what returns a client needs based on his objectives. The information used to decide on the types of investments to buy and the level of risk to takes on, can be low, medium or high.
3 Ability to take risk
The usual risk profiling exercise carried out at most financial institutions helps determine your willingness to take risk but it does not re-present your ability to take risk. Risk ability should be a ‘holistic’ concept that looks at salary, income, expenses, emergency savings, insurance coverage and goals before determining a client’s ability to lose money on an investment.
This information is based on a customer’s investment time horizon, income level, employment/income status, financial health such as cash flow and net worth and age.
4. Balancing the risk
Risk profiling questions alone is insufficient to adequately suss out a client’s risk attitude. Besides assessing risk tolerance, it seeks to understand the client’s risk capacity and ability to take risk. It believes that it is able to really understand a client’s risk appetite only after these three factors are aligned.
The problem many investors face is that their risk tolerance, risk capacity and risk ability are not the same. This is where the adviser’s responsibility comes in. Even if an investor appears to have an appetite for a product with a certain amount of risk, the adviser must steer him away if he feels that the client does not have the capacity and ability to take the risk
Summarised from Straits Times 24th March 2010
