How much risk should I take with my money?

If I were to answer that question with another question, it would simply be “How much return would you like to make?” That’s because the relationship between risk and return is one of the most fundamental concepts in managing money, and let me explain it with a simple example.

Imagine there are three people in a room, and I ask each of them to lend me Rs. 100 and make them an offer.

Person 1: He needs to jump from his standing position. If he lands without hurting himself, I will return Rs. 105. But if he injures himself, I will keep the Rs. 100.

Person 2: I ask her to climb a ladder and jump down. If she lands without injury, I will return Rs. 105. But if she hurts herself, I will keep the Rs. 100.

Person 3: I ask him to go to the second-floor balcony and jump down. Same deal–Rs. 105 if he lands okay. Zero if he doesn’t.

Now, what do you think happens?

Person 1 immediately grabs the offer. He jumps on the spot and collects Rs. 105.

Person 2 starts negotiating–she will only climb up the ladder if I better the offer. Her friend gets five bucks to jump up and down; she deserves more since she is more likely to hurt her leg. She agrees to a payout of Rs. 115 if she lands safely. She jumps, lands without incident, and collects Rs. 115.

Person 3 looks at me as if I am crazy. Why would he risk his bones for a measly Rs. 5, or even Rs. 15? He is a risk-taker but wants the rewards to be meaningful. He will jump from the second-floor balcony, but only if I pay him Rs. 500 for a safe landing. We agree, he jumps but unfortunately lands awkwardly and sprains his ankle. I call him a doctor and pocket his Rs. 100.

The Relationship between Risk and Return

And this is the relationship between risk and return. The lower the risk you take, the lower your expected return.

Person 1 took the lowest risk and made the lowest return (5%, i.e. Rs. 5 on Rs. 100 investment). Person 2 took a bit more risk and made a 15% return (Rs. 15 on Rs. 100 investment). Person 3 took the most risk and stood to make a massive return on his Rs. 100 investment. Unfortunately, it didn’t work out in this case, but he would have hit it big if it had.

This is essentially what managing money is all about–deciding how much risk you are willing to take, thereby making returns that are in line with that risk. So, for example, you can keep your money under your pillow, which is a risk-free option, but it will also give you no return. You could put in a bank account or fixed deposit at negligible risk. But that gets you a minimal return. You could buy equities, which are higher risk, but the returns will be higher too. Or you could go all out to the second-floor balcony and buy cryptocurrencies or other speculative stuff and make a lot of money. But equally, risk losing it all.

Everyone has a different appetite for risk, and there is no perfect answer to what one must do. As you embark on your financial planning journey, you must understand and accept what kind of risk-taker you are when it comes to finances. You want to develop and follow a strategy aligned with your inherent nature to take advantage of opportunities.

Knowing your Risk Profile

One standard way to understand your risk profile is by taking a survey. Any basic risk profiling survey will help you get a good sense of what your tolerance for risk is. If your banker or relationship manager has not administered this to you as yet, fire them. Seriously. It is the same as a doctor sending you for surgery without looking at any reports.

If you would like to know your risk profile, you can take this simple questionnaire and learn whether you are aggressive, balanced, or conservative when it comes to investments.

Once you know your risk profile, you should buy products broadly aligned with that. You will constantly be stressed if you are risk averse but invest in the riskiest assets like cryptocurrencies and unknown stocks. On the other hand, if you like taking risks but invest in safer assets like fixed deposits, you will lose out on potentially higher returns that you could have otherwise made.

Lastly, this exercise should be revisited often. That’s because your risk profile is not constant; your approach to risk changes with time and circumstances. For example, when you are young, you may be willing to take substantial financial risks but not as much when you have a family that depends on you.

So to your question on how much risk you should take with your money. It depends on how much risk you are comfortable with and the kind of returns that you would like. You should step out a little from your comfort zone but do not deviate too much, especially if you do not have financial experts on your side. The stress is not worth it.