Beginner’s Guide: How To Test Your Risk Appetite When It Comes to Investing

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Beginners Guide How To Test Your Risk Appetite When It Comes to Investing

Everyone wants to invest in a financial product that does not involve any risks, yet gives us double-digit returns. In the ideal world, we want guaranteed high returns.

Unfortunately, such investments do not exist anywhere in the world. This is because the nature of investment is such that it involves some risks in one form or another. After all, if there is such a good deal, everyone would be fighting to be a part of the investment, isn’t it?

Thus, given the nature of investing, the first thing that should come into our mind whenever we think about investment is risk. Many amateur investors, including myself, start out investing with the wrong mindset. We tend to think about how much returns we can potentially achieve from an investment product. We often fail to ask ourselves whether we are able to accept the risks associated with the investment.

Risk appetite is also sometimes referred to interchangeably as risk tolerance. In theory, it is the degree of variability in returns that we are willing to accept. Finance professionals like your relationship manager might use terms like drawdown. To put simply, risk appetite refers to how much loss you are willing to ‘tahan’ in order to achieve your desired investment return.

Read also: 7 Habits of Successful Investors

What is your risk appetite level?

Having written a beginners’ guide to “How To Know What Are The Right Kind Of Investments For You?”, we want to follow-up with a guide on how to test your risk appetite. By answering the following two questions truthfully, it can help you get a sense of your risk appetite. With a good understanding of your risk appetite, it will help you narrow down on the type of investments to consider.

Read also: Beginner’s Guide: When Should You Start Investing and What to Do First

1. How will you allocate your investment capital?

Testing for risk appetite is often best illustrated with an example. So, let’s imagine that you have S$10,000 to invest in any type of investment. Consider the following investment options presented to you.

  1. Investment A provides an average annual return of 3%. It comes with a minimal potential fall in the value of the original investment (the principal).
  2. The other investment, investment B, provides an average annual return of 10%. However, the value of the original investment (the principal) might decline by 20% or more in any year.

How would you allocate your capital in these two investments? Choose one of the five scenarios below:

Scenario Investment A Investment B
1 100% 0%
2 75% 25%
3 50% 50%
4 25% 75%
5 0% 100%

If you find yourself allocating more towards investment B, it signals that you have a higher risk appetite. If you chose to take the conservative choice of investing in A, it means that you have a low risk appetite. As your investment allocation in B increases, it symbolizes that you are willing to accept higher risks for higher returns.

2. What is the maximum capital loss you are willing to accept?

Next, you need to ask yourself what is the maximum capital that you are willing to accept as loss. The value of your investment portfolio will fluctuate over time. It will rise and fall in response to market movements.

Thus, at any point in time, you could be facing a paper loss. Ask yourself this question: What is the maximum loss of value you could accept in any one-year period?

Scenario Maximum Loss
1 0%
2 5%
3 10%
4 20%
5 30%

If you find yourself being put off by huge losses, it means that your willingness to accept risk is low, regardless of how good the return is.

What is your risk appetite level?

Risk appetite is often categorised into a scale of 1 to 5. If you find yourself choosing scenario 1 for both questions, it indicates that you have a low acceptance of risk. This translates to a low risk appetite (level 1). On the other hand, if you chose scenario 5 in both questions, it clearly indicates your high acceptance of risk.

Risk Appetite Level

Source: POSB

What should you invest in based on your risk appetite?

Risk appetite helps you to improve your investment by ensuring that you only invest in investments that suit your risk appetite. There are two ways you can use your risk appetite level to do that.

1. Choosing the type of asset class

The first way is to use risk appetite level to determine the type of asset class that is suited for you. Safe asset classes like fixed deposits and bonds are suitable asset classes if you have a low level of risk appetite. Medium level of risk appetite would point towards investing in assets like properties. If you have a high level of risk appetite, riskier assets like stocks (or even derivatives) might be your preferred choice.

2. Choosing the type of asset class

Another way is to use risk appetite to determine the universe of assets that you want to invest in. For example, if you decide that you would like to invest in stocks, you can use your risk appetite to determine the type of stocks to invest in. For those of you with a low risk appetite, you can choose to invest in Singapore blue chips. If you have a higher risk appetite, you can invest in mid or small-cap stocks that are riskier but offer higher potential returns.

Now that you understand how to test your risk appetite, find out what you need to set up in Singapore to take your first step in investing. Read our guide here.

 

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