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Understanding the Risk Appetite, Risk Capacity and Risk Tolerance

Investing is basically about generating returns. And the most important factor deriving the returns on investment is risk. Risk is directly proportional to returns. In other words, higher the risk, higher the return. While it is applicable in investment, mutual funds investment is not an exception. Various mutual funds schemes have different levels of risk. Similarly, even the investors are different with respect to the levels of risk they are comfortable with.

While there are different investors like aggressive, moderate and conservative, it is important for investors to understand their own risk profile. At times there are also differences between the level of risk the investors think they are comfortable with, and the level of risk they actually are comfortable with.


Investment is an act dependent on understanding two important aspects of risk. First is the risk appetite of the investor and second is the risk level of the investment option. Here we are going to focus on the first aspect of risk appetite of investors. Based on the risk appetite an investor can be divided in three major categories vis-à-vis, aggressive, moderate and conservative.


An aggressive investor takes higher risk to generate higher returns. On the other hand, a moderate investor tries to generate higher than risk free returns. Lastly, a conservative investor would hardly take any risk and looks for risk free kind of investments. This gives us a broader classification of the actual risk appetite depending on various factors. Before understanding those factors – let us first understand the difference between three commonly used words for risk appetite. While many use them interchangeably the terms are different.


Risk appetite, risk capacity and risk tolerance


The investment choices that an individual makes should be aligned to their risk profile. The risk profile defines the level of risk that an investor is willing and most importantly is able to take. This in turn will determine their asset allocation to different mutual funds schemes. It will further decide the choice of investment products and further operational decisions like rebalancing the portfolio and exiting an investment if required. But before taking such calls it is important to understand the difference between risk appetite, risk capacity and risk tolerance.


Risk appetite is the willingness of an investor to take risks to achieve their strategic investment objectives or financial goals. The problem occurs when we are not able to measure the risk appetite and then invest in the wrong asset class. For instance, everyone wants to buy an expensive car. But how many would be able to actually buy the same? The willingness to buy a thing and the ability to buy is completely different. In other words, the risk appetite of an investor must be aligned to their risk capacity, or their ability to take risk.

Risk capacity is the capacity to take risk depending upon personal factors like the age of the investor, income levels and stability of income, the wealth of the investor, time to the goal, liquidity needs, dependents and few other factors. An investor with a high, stable income, saving for the retirement goal has a high capacity for risk. On the other hand, a person in a single income family with multiple dependents with not a very high income has a low risk capacity. Similarly, an investor with a high risk capacity may have a low or medium risk appetite and choose investment products accordingly. Such investors are willing to trade-off returns for lower risk. However, if an investor with a low risk capacity has a high risk appetite and invests in higher risk products, then they may be taking on more risk than they can handle to garner better returns. Just imagine a significant fall in the value of the investments is likely to destabilize their overall financial situation at risk.


The risk tolerance of an investor defines the limits or boundaries of the risk that an investor is willing to take. For instance, an investor may define their downside risk tolerance limit as a fall of 15 per cent in the principal value invested. It is also known as the maximum drawdown one can accept in terms of investment. In other words, when this level of margin is breached, the investor is likely to implement measures to limit the loss such by exiting the investment or in some cases rebalancing the portfolio. Overall, the risk tolerance triggers operational decisions in managing the portfolio. For an investor to have a portfolio of investment that suits them, all these risk measures have to be determined and defined correctly.


Factors influencing the investor’s risk profile


The risk profile is dependent on broad factors like family information, personal information and most importantly financial information.


Family information


The family information is categorised into three factors vis-à-vis, earning members, dependent members and lastly life expectancy. In case of earning members the risk appetite increases as the number of earning members increases. The risk appetite of single bread earners would be lower compared to a dual income home. The second factor here is dependent members. Risk appetite decreases as the number of dependent members increases. Even the life expectancy influences the risk appetite. Risk appetite is higher when life expectancy is longer.


Personal information


The first parameter here is age. The earlier one starts investing, the better it is. In early career the risk taking capability is higher as life expectancy is longer and number of dependents are also lesser. Employability is also a prime factor. Well-qualified and multi-skilled professionals can afford to take more risk as the employability chances would be better in this case. Here the nature of the job also influences the risk appetite. A person having a consistent job with growth prospects would have a higher risk appetite. After this the investor psyche also plays a vital role. Daring and adventurous people are better positioned mentally, to accept the downsides that come with risk. For these investors, the capacity and tolerance would be crucial here.


Financial information


While the above two parameters are quite subjective, financial information is a very objective one. Capital base and regularity of income are two financial factors influencing the risk appetite. As for the capital base, bigger the game means bigger the appetite. In other words, higher the capital base, better the ability to financially take the downsides that come with risk. Deep pockets usually come in handy to sustain through the volatility in markets. People earning regular income can take more risk than those with unpredictable income streams. A person with a regular income can also go for systematic investment plans (SIPs) being continued for longer periods.


 

Conclusion: One may think about taking higher risk to garner higher returns. However, it is advisable to understand the risk appetite, risk capacity and risk tolerance. Analyse the parameters like family, personal and financial information to make the right risk profile and then select the investment vehicle accordingly. If one is unable to access the risk profile it is advisable to take professional help.


Pro Tip: To select a right investment asset it is important to differentiate between risk appetite, risk capacity and risk tolerance.


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