Risk is the most commonly used buzzword in any conversation or communication around investing. While this popularity exists for good reason, it can be quite daunting for beginners to immediately face the hullabaloo around risks in investing. Intimidated as they are by the prospect of venturing into a field so diverse, complex, and technical, the jargon and furore around risk can completely put them off. This discouragement would never help their goal of building long-term wealth!
That is why in this blog, we are breaking down the concept of risk for beginners, helping you understand what risk tolerance and risk appetite are. In doing so, we will also take you through the difference between the two terms.
Before we get into that, here are some points you should keep in mind while starting as a beginner in investment:
- Start by setting your long-term financial goals
- Remain calm and don’t let your emotions control you or your financial decisions
- Take guidance from a digital wealth management platform like Tailwind to understand what investment options are suitable for you and your goals
- Focus on portfolio diversification early on in your journey
With this out of the way, let’s closely look at the most common investment advice given to beginners: bear your risk appetite and risk tolerance in mind while investing.
What is the risk appetite?
One of the first things you do when starting your investment journey is to determine your risk appetite. It is defined as the level of risk that you are willing to accept while pursuing your goal based financial planning objectives before looking at different options you can explore to reduce the risk.
The criteria to determine your risk appetite can be vast and subjective. However, some common parameters include age, financial goals, income, family’s financial background, subject matter expertise, etc. For example, an 18 y/o college student from a well-off family can have a higher risk appetite because of the advantages of young age, familial capital, and lack of responsibilities.
What is risk tolerance?
Risk tolerance is a much more nuanced and subjective concept, as compared to risk appetite. Risk tolerance is defined as the acceptable deviation from the risk appetite. In practice, it is the amount of risk you are willing to or can afford to actually tolerate, even if it proves to be higher or lower than your risk appetite.
Thus, your risk tolerance is more realistic than your risk appetite. You might be able to afford a higher risk, but you can very well be tolerant towards a low-risk investment exclusively.
Understanding the difference
Although both terms can be used interchangeably, let’s look at them closely to see how they differ. A key pragmatic difference between the two is that you determine your risk appetite before investing in any instrument. However, once that investment is made, the fluctuation in your investment value as determined by market volatility tests your risk tolerance.
Thus, an investor with a high risk appetite can invest in a few options that are low-risk simply because his/her risk tolerance for that particular instrument is low. Factors such as the size of the investment, nature of the financial instrument, subject matter expertise of the investor, etc. influence risk tolerance.
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