There are a lot of 'Risk Tolerance' measures out there which asks you a bunch of questions, and then tells you your Risk Profile. Most of the time, they pretty much tell you what you already know. Most of us have a good sense of the kind of risk we can stomach so we don't really need a test to tell us that.

What you might not be aware of, however, is that your life situation might demand that you take on specific levels of risk, no matter what your risk appetite might be. It is not a matter of what kind of risks you want to take, it's a matter of what kind of risks you can take given the circumstances that you are in.

These are the Fundsupermart rules for determining the amount of risk you can take given your life situation.  

1. Time Horizon (or Age) : 

The longer your time horizon (or, the younger you are), the more risk you can take. The more time you have, the more you are able to ride out market cycles and volatility, so that you never sell at a loss, but always at a profit. Also, the power of compounding increases the worth of your portfolio dramatically with time. 

Conversely, the less time you have (or, older you are), the less risk you can take. If you are close to retirement, it is best that you invest your money in stable, conservative unit trusts. This is because you don't want to be caught in a down market cycle when you need your money. You would have to sell at a loss.

2. Risk Transition :

As your investment horizon approaches, you have to scale down the level of risks which you take in your investments. For example, you might have bought high risk, high returns unit trusts for your retirement in 20 years time. In 15 years time, it is wise to scale down to medium risks products, and then low risks products in 18 years time. This way you preserve the gains you have gotten in the early years. 

3. Savings :

If you have at least 4 - 6 months pay worth of savings tucked away, you are more able to invest in high risk unit trusts. In case of any emergency, you would have sufficient cash to tide you through, and you do not need to liquidate your investments. 

If you do not have this amount in cash but would still like to invest, it's best to keep your investments to low risk unit trusts. In case you need to redeem it, you are less likely to be caught with high losses.

4. Lifestyle needs :

Take a good look at your lifestyle requirements. How do you imagine yourself retiring? Or what is the goal for which you are investing? If you feel that you can be happy with a simple 4 room HDB flat when you retire, then there is no need for you to take high risks, no matter what your age might be. 

Do not invest in high risk products simply because everybody else is doing it. Determine what you need and invest accordingly. 

Conclusion

Generally, there is a good correlation between risks and returns. The higher the risks, the higher the returns are likely to be. However, the key word here is 'likely'. There is no guarantee. High risks instruments can sometimes crash, and lead to large losses. 

So you have to be very mindful of whether your life situation allows you to handle such a crash. If not, it is better to choose less risk products. No matter what you perceive your risk 'appetite' to be.