5 Things to Consider While Evaluating Your Risk Appetite

April 13, 2023 Mutual Fund

While investing, it is essential to determine your risk profile. Allocating your hard-earned money to the desired investment avenues without determining your risk tolerance could be disastrous.

“Mutual Fund Investments are subject to market risks; please read the scheme-related documents carefully.”

You may have heard this quick disclaimer about mutual fund investments. You see, regardless of whether you invest in mutual funds, stocks, bonds, or any other market-linked instrument, all investment options entail a certain level of risk. As a result, when investing, you must understand your risk profile and take calculated risks.

Mutual fund schemes are classified as low, medium, or high risk based on the securities and asset classes in which they invest. Often many investors get lured by a mutual fund scheme just by looking at its past returns. At this point, investors fail to match their risk profile with the underlying risk of the instrument and invest their hard-earned money, and eventually end up regretting their investment decision.

Thus, it is crucial to perform risk profiling that helps you find the optimum level of risk you can take. Based on this, you can decide your ideal investment option.

But the question arises… How do you define your risk appetite?

In this article, I will tell you how to quantify your risk-taking ability and help you understand the aspects you need to consider in order to assess your risk appetite.

What is a risk appetite?

Risk appetite is a universal concept of the desired level of risk that one will take with their investments in order to achieve a financial goal. Investors may mistake risk appetite for risk tolerance. Yet, risk appetite relates to an individual’s propensity to take a risk, whereas risk tolerance refers to an investor’s psychological willingness to tolerate risk.

Risk tolerance represents the tolerable range in investment outcome; it denotes an individual’s ability to bear a certain level of downside risk.

Let’s understand this through an example.

Each investor has a different risk tolerance level. For example, Mr A has a high-risk appetite along with the willingness to take high-risk. This makes him an aggressive investor. Similarly, Mr B has a high-risk appetite but with the willingness to take a medium risk. This makes him a moderately risk taking investor.

Here are 5 important aspects to consider while evaluating your risk appetite:

1. Financial situation

What is your current financial situation?

• Your Income
• Expenses
• Assets
• Liabilities
• Financial responsibility you are shouldering, etc.

The current financial situation of an individual may even influence their risk appetite. Individuals with a greater discretionary income and lesser financial responsibilities may be more willing to participate in risky ventures. Also, current financial stability is vital in determining one’s risk tolerance levels.

For example, if you have appropriate emergency funds, insurance coverage for you and your family, and retirement investments, embracing additional risk may be an option to maximise your returns. Your disposable income is the amount left over after deducting your expenses. If your disposable income is substantial, you can take greater risks because you are not entirely reliant on investment income. Losses, on the other hand, are unaffordable if your disposable income is low.

2. Investment horizon

Next, you must think about your investment horizon. The duration for which an investor plans to hold an investment can also affect their risk appetite. Long-term investors may be willing to take on riskier investments because they have more time to weather the impact of any short-term market dynamics. The time horizon is critical in assessing one’s risk appetite.

If you have a long-term horizon, then you can afford to expose your portfolio to high-risk investment avenues. Whereas, if you have a short-term horizon like for a year, then investing in a low to medium risk investment option is ideal for you.

3. Age of the investor

As time passes, your risk tolerance shifts gradually. The investment horizon of an investor is an important consideration because elderly investors may have a lower risk appetite than younger ones. Investors in their 20s and 30s can afford to take more risks as they can retain investments for a longer period of time. As a result, equity mutual funds are their preferred investment option. Investors in their 50s, on the other hand, may prefer low risk investment options such as fixed deposits or debt mutual funds. Thus, age is also important in determining your investment horizon and risk profile.

There is also a rule that helps you determine your risk profile based on your age. It is known as the ‘100 minus age’ rule and is a traditional guideline for allocating your investments to risky and less risky assets. It states that 100 represents your risk tolerance and that as you become older, you deduct your current age from 100. As a result, the maximum percentage of the investor’s portfolio should be allocated to high-risk investments, depending on their age. For a 30-year-old investor, this rule implies that no more than 70% (100 – 30 yrs.) of his portfolio should be put in equities, with the balance in debt.

4. Market knowledge and experience

An investor’s knowledge and experience in the financial markets can also be used to measure their risk tolerance. Many of you may have started investing after weighing the pros and cons; on the other hand, some of you may have started randomly and developed an understanding later. This experience in the market is unique to each one of us.

Your risk profile hinges much on your comfort level with market volatility. Savvy investors may be willing to take on riskier investments because they have a better understanding of how the markets work. Adequate market knowledge instils confidence about the instrument you are investing in, which aids in strategizing according to the prevailing market conditions.

5. Investor’s attitude and willingness

This is the most overlooked factor when assessing an individual’s risk profile. An investor’s attitude and belief might also have an impact on his/her risk tolerance. Someone who values financial security and stability, for example, may be less likely to make risky investments, whereas someone who is more at ease with uncertainty and volatility may be more willing to take a high risk.

Also, your personal financial goals may influence your risk tolerance level. While some goals can be postponed, others, such as investing for your child’s education have a set time frame and cannot be delayed. On the other hand, some goals can be negotiable and postponed, such as buying a car, going on a vacation, or buying your own house. Normally, you would not like to take an unwarranted risk with your non-negotiable goals. Your negotiable goals can entail some risk depending on the specifics of your case.

Remember, the risk profile of each investor is different. But the problem is most investors do not understand how to diversify their portfolio according to their risk appetite.

To conclude…

Investors often invest their hard-earned money based on the suggestions from their friends or relatives without aligning their risk profile with the underlying risk profile of the investment instrument. Such impulsive investments can be detrimental to your financial health.

If you are afraid of heights, would you go bungee jumping? No, because it appears risky for you. Similarly, if you understand your risk profile, you will not put your hard-earned money in any random investment option. As a result, assessing your risk profile is essential for making sound investing decisions. It aids in sensible asset allocation and optimising the risk-return relationship for your investment portfolio. Remember that the return on your investment comes with risks, so don’t rush into mutual fund schemes that offer higher returns. Ask yourself, whether you can afford to take the risks involved.

This article first appeared on PersonalFN here