Sunday, January 24, 2010

Investing Risk Factors

We all know in finance, higher returns equals higher risk. It's a basic fact of investing, yet working out just how much of a gamble you are willing to take with your hard earned cash is far harder to pin down.

The other side of the story is when individual get so caught up chasing higher returns they ignore the risk factor.
The willingness to take risk is just one facet in managing investment risk. It is even more important to ask yourself this: Do you need to? Are you able to afford to lose?

Here are three factors you should consider before investing:

-Willingness to take risk
Simply put, the willingness to take risk - called risk tolerance - reflects your attitude towards risk. It is the amount of risk you are comfortable taking, or the degree of uncertainty you can handle or if should you lose, are you still liquid in your assets.

For example, if you can sleep soundly even when your investments are experiencing dramatic swings in value, you are considered risk-tolerant. But if they keep you up at night, you are risk-averse.
Risk tolerance often varies with age, income and financial goals. Risk tolerance levels are usually classified as aggressive, balanced or conservative. Each level helps determine the percentage of equities and bonds to hold. Equities are deemed riskier than bonds.

-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.
Perhaps your risk profiling score indicates that you are an aggressive investor who can withstand high portfolio volatility.

But there may be no need for you to undertake the new risk because you may be already close to meeting your financial goals.
The need to take risk - called risk capacity - is based on what returns a client needs based on his objectives.

- 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.
Let's say the risk profile questionnaire indicates that you are a high-risk investor, but if you look at your financial health and commitments, it may show that you have a lot of debt. This means that you are unable to take high risks even though your risk profile says otherwise.

In some banks, they assesses risk ability and overall pro-duct suitability by collecting information on a customer's investment time horizon, income level, employment/income status, financial health such as cash flow and net worth and age.

Balancing Risk

Providend maintains that using the 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 three factors help determine the amount of risk that should be taken in a portfolio of investments.
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.  Example, the GP cannot say he prescribed sleeping pills because that was what the patient wanted. In the same way, the adviser or the financial institution cannot say that he or it sold a client a high-risk investment which was not suitable for him because of the client's lack of risk ability, simply because that was what the client wanted.

Professionals owe a duty of care and they should give professional advice including advising an eager customer against investments which are unsuitable for the customer.
In a scenario where making an investment would result in a breach of these thresholds, the bank will either advise the customer to reduce his investment amount to a level within his risk capacity or advise him against making the investment.

As said, be prudent and careful, do not jump into the bandwagon like many who suffered in last year bonds issue.

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