Does your risk appetite influence your investment decision?

It is the expectation of reward or return on an amount invested for the future that motivates people to commit their current pool of funds into an investment.

People’s circumstances change in life, and therefore their risk-taking ability changes with age and with changes in their financial net worth, return on investment (i.e. interest rate) and financial needs over their life period.

For instance, people who are young and below 40-years of age have multiple decades of their working life ahead of them. Their risk-taking ability therefore differs significantly from someone who has retired and is above 60-years of age.

The persons above 60-years of age are expected to live on their pension and from interest/income from their savings. Therefore, an older person’s risk-taking ability differs significantly from a young person’s risk-taking ability. The older people, in general, can be expected to be more inclined toward investing in less risky investment avenues.

Risk appetite can be defined as the amount and type of risk that an individual or organisation is willing to take in order to meet their strategic or financial objectives. Individual Investors or organisations will have different risk appetites depending on their sector, culture and objectives. A range of appetites exist for different risks, and these may change over time.

Risk tolerance goes a long way in defining the kind of investments a person can and should make. The risk tolerance of a person depends on the following factors:

  • A person’s psychological make-up.
  • A person’s current financial status and income expectations.
  • A person’s family circumstances. For instance, is the person the sole breadwinner for the family? Does he have a large family to support?
  • A person’s age (i.e. younger people have decades of work-life left, so they can have a greater portion of high-risk, high-return investments in their portfolio. Older people have fewer working years, so they would be more inclined toward capital preservation than capital appreciation).

 

As interest rates decline, individual investors will naturally desire new investment instruments that will continue to give the same amount of returns as they were earning. The desire for high interest rates goes with a certain level of risk that an investor will come face to face with. It is important for investors to understand that as long as returns on investment (i.e. interest rate) is above inflation, then the purchasing power of investors is still secure.

Others will argue about exchange rate fluctuations impacting on the purchasing power of the consumer (i.e., Investor). For those who import goods to sell, it is important to find the rate of cedi-depreciation and add it to inflation and see the impact. Once your returns on investment support your consumptions desires in the future, then your financial goals will be met.

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For example, if a person desires to purchase shoes or a dress three months from now (i.e. June 2019), the key question is: what will the price of shoes be in three months? So that by investing, one can purchase the same shoes or dress. The truth is that we all invest to spend in the future. We only defer current consumption for future consumption. However, the amount of returns a person desires will determine the probability of losing or getting his or her investment back.

There have been instances when some financial institutions or fraudulent companies offer investors abnormal returns on investment – and still investors place their funds with them. This means that investors are either ignorant about risk or return, or want to beat the system in a smart way or they are too greedy. Whatever the reasons may be, investors need to establish their risk appetite – including where the funds will be invested and how to monitor the investment until maturity.

Investors needs to question institutions offering high rates of return over and above market rates, especially where their funds are going to be invested. Investors who lack the needed skills should contact investment advisers/financial advisers to assist with necessary research. If this is done well, investors’ desire for high return will be influenced by their appreciation of the kind of risk they are buying into and whether it meets their investment objectives.

Institutions that engage in the business of loans need strong risk management and credit analysis departments in order to select quality loan requests and ensure the quality of their loan book. Currently, a lot of banks and loans companies have huge non-performing loans. Institutions which lack a strong risk management unit will continue to have loan defaulters because their inability to forecast repayment of facilities.

Some financial institutions are venturing into alternative investment instruments – such as real estate investment, commodities, gold etc. – without knowledge of their clients or understanding the sectors. This is the causing a lot of loan defaulters in the system, and therefore affecting good institutions which have the capacity to repay loans granted to them.

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Client’s knowledge of the kind of risk they are assuming and its associated return will inform their financial goals or objective, and therefore the answers to the questions below.

The key questions that investors must ask themselves as interest rates keep on declining are:

  • How do I maintain my purchasing power without taking on more risk?
  • Which investment products are financial institutions offering high interest rates going to invest their funds in?
  • Are the financial institutions having liquidity challenges, so that is why they are offering attractive interest rates to address their liquidity challenges?
  • Am I ready to take on more risk?
  • Do more returns mean the probability of losing investment?
  • What is their financial statement communicating?
  • How do I secure myself as l invest in a particular financial institution?
  • Are they fully licenced to engage in the service they are offering?

For the above questions to be addressed, investors need to align their financial goals with risk appetite and returns on investment.

It is important for Investors to note that financial goals usually begin with the acquisition stage of capital accumulation, involving savings and investments. Therefore, the financial planning process – as in establishing a business – is to establish goals that are realistic and attainable. Every individual desires to achieve financial success in life. We all have this general goal, but we must become precise in terms of specific dollar or cedi amounts desired.

The time-frame for these financial goals and the associated risk that comes with them are crucial to investment decisions.  Once capital is acquired, capital must be maintained and preserved. To actually preserve capital, we must invest in financial instruments or vehicles that will provide us with a return that is greater than the inflation rate – and that will take into consideration our individual tolerance for risk.

 

FOLLOW OUR MONTHLY PUBLICATION ON MONDAY 29TH APRIL 2019 FOR THE NEXT PUBLICATION.

Disclaimer:

Statements and opinions expressed in the article or review herein are those of Glorygate Capital Limited. While every care has been taken in the compilation of this information and every attempt made to present up-to-date and accurate information, we cannot guarantee that inaccuracies will not occur. Glorygate Capital Limited will not be held responsible for any claim, loss, damage or inconvenience caused as a result of any information within this article or review.

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