Investment Risk Rating Chart

One of the basics of investing is understanding your risk tolerance. Risk tolerance is the degree of variability in investment returns that an investor is willing to withstand in their portfolio. It is common for your tolerance to vary based on your age, income capacity and financial goals.

Are you risk tolerant or risk averse? What products should you invest in based on your tolerance?

Our investment risk flow chart was initially created for a client for three purposes:

1) To better understand the different types of investment products on the market.

2) To determine the risk associated with each product.

3) To determine what products are best suited based on their risk tolerance.

The infographic was a simple way to unravel all the investor jargon and provide an easy metric to determine what products would be most appropriate based on the client's risk tolerance. (yes, we go above and beyond for our clients!). Also important to note, this scale was created based on the ease of access, liquidity, interest rates and credit ratings of financial products in the Caribbean as well as access/restrictions to international financial products by a Caribbean national.

Liquidity, time and the credit rating of the company/issuer all play important roles in assessing the level of risk associated with each type of financial product. In some cases, depending how these factors interact, a product can move higher or lower on the scale.

Things can sometimes get a bit complicated here.

For example, a bond is rated as low - medium risk with slightly above average returns mainly attributed to the long term nature of bonds. If a business has a history of default or has financial troubles on the horizon investors in turn will demand a high return for taking on the additional risk.

Think of it this way, you are purchasing a carton of milk and there are two options to choose from. One carton expires tomorrow and the other next week. With both cartons priced at $2.99 would you purchase the milk expiring tomorrow or the one that expires next week? One for next week right? No rational person would accept the risk of the milk spoiling before they can consume for the SAME price.

What if the milk expiring tomorrow is priced at $0.99, would you reconsonsider? It's definitely now worth a thought.

The risk here is that the milk is close to expiry and therefore might spoil before consumption. Hence why the seller has offered the buyer the discount; the discount is the incentive (better return) for accepting some degree of risk.

Now let's add the element of time, in this case consumption date. What if we intend to consume the milk today. You no longer have the event of the milk spoiling before you consume. This has now transformed that $0.99 carton of milk into a steal of a deal! The individual who chooses this option would be considered risk tolerant; they are willing to accept a reasonable level of risk for the better return (price).

On the other side of the coin are those individuals that would not want to take this risk and rather purchase the milk full price even if they were consuming today. This person would be considered risk averse. Remember, we assess risk differently based on our tolerance.

Back to our bond, a higher than normal return on a bond means that there is a higher risk of default. (i.e the milk might be spoiling soon)

As we can see from the above, several scenarios can play out in the investment world and we can assess investments differently based on the risk we are willing to accept. However, conventional theory holds in most circumstances.

The risk to reward ratio theory holds true in most instances, that is, the higher the return the higher the risk.

Risk Rating Chart Guide

RISK RATING

Green - Low risk; low returns

Yellow - Medium risk; average returns

Red - Medium - High risk; High returns

FINANCIAL PRODUCT

Green - Savings Account & Fixed Deposits

Yellow - Bonds, Mutual Funds & ETF's

Red - Stocks, Forex and Derivative Trading

Disclaimer: The information provided in this article are for educational purposes only, intended for analysing, learning and discussing general and generic information. This information is not to be taken as investment advice, please seek professional guidance before making any financial decisions.