Risk Appetite And Risk Tolerance
The second step is to develop your own risk profile.
Your risk profile is made up of two components –
- Risk appetite
- Risk tolerance
Risk appetite simply refers to how much risk one is willing to accept. Risk tolerance indicates how much risk our finances can actually handle. The two might be very different. Let us consider an example to understand how each of them work with a hypothetical case. Mr. Arka Roy is a young man, married with a child. His risk appetite may be high. What does this mean?
This may be based on his investing tendencies. In case he has done well with equity in the past he might feel confident about it in the future as well and therefore, he might have a high appetite for risk. However, based on his financial situation, which comprises factors such as the level of emergency fund he maintains, or any loan EMIs that are chipping away at his income and so on, his risk tolerance might be very low indeed.
You should assess your own risk profile to know where you stand compared to your own risk appetite and risk tolerance. Sometimes you do everything that is necessary to provide financial safety, but situations may still arise that pushes you out of your comfort zone. There may be a financial emergency or an urgent requirement for funds.
There are two ways to deal with such a situation. They are as follows:
1. The first way to prepare for a financial emergency is to have a contingency reserve of 6 to 12 months of your annual living expenses (including EMIs if any). This can be maintained in a liquid mutual fund and partly in a savings bank account for quick access.
2. The second thing that will help in such situations is having the right kind of insurance.