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Even the most well-planned investment strategies can end up losing money if the market turns against them.
And while you can’t plan for every possible outcome, you can make a judgement on how likely your investments are to lose money – and whether they’re appropriate for your circumstances.
Investors call this their ‘risk appetite’ – how much money they’re willing to put on the line in order to generate the kinds of returns they want to see.
Let’s look at how you can measure your risk appetite and use it to build your portfolio.
Understanding risk and return
While we all hope our investments will rise in value over time, that’s not always the case and even our best-laid plans can sometimes result in losses. In investment circles, the likelihood of making a loss (or ‘negative return’) is referred to as ‘risk’.
An asset is considered high risk if either:
- the likelihood of losing money is high, or
- the total amount an investor stands to lose is significant.
Although higher risk assets attract a greater likelihood of losing money, they can also give investors the opportunity to earn higher returns (although this isn’t guaranteed).
Take small cap stocks for example. Share prices for these smaller companies tend to be more volatile than larger companies. This means their day-to-day price movements veer further away from the share price’s long run average in both directions.
Bad news could send their share prices tumbling, but good news could see it head up again.
Lower risk investments tend to be safer but return less. A good example of this is your savings account. There’s very little risk to your cash, but the interest you earn isn’t as big as the returns offered by other investments.
This is known as the risk/return ‘trade off’. In other words, if you want to make a higher return you have to take more risk.
Why do markets fluctuate?
Assets are priced based on how much other investors are willing to pay for them. On an individual level, investors might be willing to pay more for a company with strong sales and little debt than another business in a tighter financial position.
On a broader, whole-of-market level there are several macro-economic factors that can influence the price investors are willing to pay for entire industries, asset types, or even markets.
Rising interest rates, for example, can weigh on shares because investors might worry about higher borrowing costs for businesses.
As a result, changes in the political, economic, industrial, or social environment can cause fluctuations in markets.
Importantly, these shifts in the market often happen in cycles. These cycles tend to move through four phases:
- Optimism: This is when investors start buying up assets again after the market has bottomed out.
- Euphoria: Asset prices climb steadily after the market has been stable for a while and investors feel more confident.
- Fear: Suspecting that the market may be near its peak, investors begin selling their assets.
- Capitulation: Prices begin to tumble amid all the selling. Once they reach their bottom, the cycle starts again as investors become more optimistic.
It’s important to remember markets move in cycles – especially when asset prices are turbulent.
What is risk appetite?
Put simply, risk appetite describes how willing an investor is to accept financial losses.
Investors might have a high-risk appetite because they’re investing over a long timeframe and are confident the returns will come with time.
Or perhaps they have other sources of wealth to support them and they can afford to take a chance on higher risk investment strategies.
Typically, high risk investors have a good understanding of investment markets and know that gains and losses can happen quickly.
Some younger investors might have a higher risk appetite because they have what is called a ‘long time horizon’. Although they have a higher likelihood of a negative return in the short term, they also have more time to ride out the ups and downs of the market.
Conversely, older people and investors who need quick access to cash in the short term tend to have lower risk appetites. These conservative investors usually hold a greater proportion of defensive assets.
Those in the middle are called ‘moderate investors’.
How do I choose investments based on my risk appetite?
Understanding your own risk appetite will help you choose what to invest in to get the best return without taking on more risk than you can handle.
Our Risk Profiler Tool can help you better understand your risk appetite and provide a rough guide on the types of assets and the investment horizon you’ll need to achieve your goals.
Alternatively, you’ll need to answer each of the following questions with ‘low’, ‘medium’ or ‘high’:
- What length of time will you be able to stay invested?
- How comfortable are you with a negative return?
- What level of investing experience do you have?
- What kind of returns would you like to receive?
If you answered mainly ‘low’, your risk appetite is likely also low. Similarly, mostly ‘medium’ suggests you probably only have a moderate risk appetite.
It gets a bit trickier if you answered mostly ‘high’. This could indicate you have a high-risk appetite, but if your answer to question one was ‘low’ or ‘medium’ your risk appetite is likely to be either ‘low’ or ‘medium’ – regardless of how you answered questions two to four.
Once you know your own risk appetite, you can choose investment options to match, including within your super, pension, and investments.
Our tools and calculators can also provide you with a deeper understanding of your financial situation so you can make more informed decisions about your financial future. And if you need additional support, a financial adviser can assess your risk appetite, select investments and create a plan that’s appropriate for your needs. If you don’t have an adviser, you can locate one near you using our find an adviser service.
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Avanteos Investments Limited ABN 20 096 259 979, AFSL 245531 (AIL) is the trustee of the Colonial First State FirstChoice Superannuation Trust ABN 26 458 298 557 and issuer of FirstChoice range of super and pension products. Colonial First State Investments Limited ABN 98 002 348 352, AFSL 232468 (CFSIL) is the responsible entity and issuer of products made available under FirstChoice Investments and FirstChoice Wholesale Investments.Information on this webpage is provided by AIL and CFSIL. It may include general advice but does not consider your individual objectives, financial situation, needs or tax circumstances. You can find the target market determinations (TMD) for our financial products at www.cfs.com.au/tmd, which include a description of who a financial product might suit. You should read the relevant Product Disclosure Statement (PDS) and Financial Services Guide (FSG) carefully, assess whether the information is appropriate for you, and consider talking to a financial adviser before making an investment decision. You can get the PDS and FSG at www.cfs.com.au or by calling us on 13 13 36.