A good financial adviser should always assess your ‘risk appetite’ and circumstances before making any recommendations. But what exactly is a ‘risk appetite’ and how do you determine yours?

A quick way to get a general sense of your ‘risk appetite’ would be to consider which of these sayings most appeals to you: ‘A bird in the hand is worth two in the bush’, ‘Nothing ventured, nothing gained’, or ‘Speculate to accumulate!’

Investing involves a variety of risks, including the risk of a decline in the value of a security or a portfolio (price risk), the risk your money will not keep up with rising prices (inflation risk), the risk that an institution will fail (default risk), and the risk that you could have earned better returns elsewhere (interest rate risk).

Risk appetite, also called risk tolerance, is a broad-based description used in the investment world to indicate the desired level of risk that one is willing to take in pursuit of one’s investment goal. Or to put it more bluntly, it is the amount of money that an investor can afford to lose in his or her quest for a desired return on investments.

When evaluating your willingness to take on risk, first consider your investment goals. How long-term are they? How vital is it that this money is available on a determined date? What kind of returns do you desire? If you have a short-term goal — for example, saving for university fees or a car — your appetite for risk would usually be low, as the need for certainty should reduce the amount of risk that you are willing to take. You do not want to be worrying about the state of the financial markets when you need your money to be readily accessible.

A longer time frame gives your investment more time to recover if it falls in value, and so, in general, the longer the investment time, the better the risk tolerance. The bigger your goal in relation to the assets or income you wish to invest, the greater the rate of return required to hit your goal. Taking no risk at all may make your goals impossible to achieve — taking too much may cause you to lose your investment.

Secondly, consider your personal circumstances — how much can you afford to lose? Ask yourself, what would happen if you lost some or all of the money you are putting into investments. This will depend on your circumstances and what percentage of your money you are investing.

Do you have people who depend on you financially and any other important financial commitment? Those in a stronger financial position may be willing and able to invest in financial products with higher risk, while those in a weaker financial position may be more suited to low-risk products.

For example, a 30-year-old with no liabilities, some savings, and a healthy disposable income, is likely to be able to stomach considerably more risk than a 65-year-old with limited assets and a pension which barely covers his/her expenses. However, there are some older investors with substantial asset pools or significant income streams for whom a loss would not materially impact their financial well-being; in which case, a higher tolerance for risk could be appropriate.

Finally, consider your personal attitude to risk. Risk attitude is subjective and is likely to be influenced by current events or recent experiences. When stock markets are rising we tend to feel comfortable with market risk, but when they are falling, we do not.

Most people are not comfortable with the idea of losing money. On the other hand, we may regret it if we have been overly cautious and our long-term investments do not produce the returns we need.

If the ups and downs of the market give you sleepless nights, then you should consider investing in low-risk products and your risk appetite would be low. Personal attitude to risk is hard to measure and can be changeable — what feels comfortable one day may not the next. Therefore, of these three things I have mentioned, your investment goals and capacity for loss are the most important.

The risk appetite descriptions used by institutions vary, and sometimes there are subcategories, but in general, someone who is willing to take only a little investment risk is ‘conservative’, an investor who is willing to accept some risk and fluctuations for higher potential returns is said to be ‘moderate’, and finally, an investor who wants to maximise his/her potential returns, even if it means significant fluctuations and possible loss of principal, is categorised as ‘aggressive’.

When risk appetite is properly understood and clearly defined it becomes a powerful tool, not only for managing risk but also for enhancing the overall return of your investment portfolio.

Therefore, once you have determined your risk appetite, use that knowledge to make or review your investment plan. And remember, your appetite may change over time, so it is recommended that you do periodic reviews of your portfolio and make adjustments if necessary.

Toni-Ann Neita is assistant vice-president — Personal Financial Planning at Sterling Asset Management. Sterling provides medium to long-term financial advice and investments in US and other world market currencies to the corporate, individual and institutional investor. Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at:info@sterlingasset.net.jm. You may visit us on Facebook or follow us on Twitter, and for more information please visit our website www.sterling.com.jm