How To Assess Risk Appetite? Is It Different From Risk Capacity?

Our clients often tell us that they are okay with high risk, or not fine with it, but the interpretation of risk may vary from person to person. Thus, there needs to be a scientific base to determine what every individual’s risk appetite is. There are psychometric measures which are derived from a bunch of 15-20 questions that can help rate a person’s risk appetite in numerical terms. This leads to the classifications of aggressive, moderate and conservative investor categories and a few more in between, such as the moderately aggressive. This exercise helps in determining the threshold of exposure (to growth or risks of assets) beyond which the investor will not be comfortable.

Let’s understand this with an example. If you are comfortable with losing 5 per cent of your net worth, and equity markets could lose 20 per cent at any time, one way to look at this would be to restrict your investments in equity to 25 per cent. Of course, your risk appetite would also impact the potential to generate returns.  

Risk capacity refers to the amount of risk that investors must take to achieve their goals. To make an analogy with a one-day cricket match, if the required run rate to win climbs, the batsman has to attempt to hit a boundary or a six even though there is the risk of losing the wicket. In the above example, if the investor needs a return of 10 per cent per annum to meet the goals, and if equity will generate 12.5 per cent and fixed income 7.5 per cent, the investor will necessarily have to allocate 50 per cent to growth assets. If the investor sticks to investing in line with the risk appetite, the potential returns generated will be 8.75 per cent per annum, (25 per cent in equity and 75 per cent in fixed income), thereby reducing the chances of achieving the financial goals.

We suggest that the risk appetite questionnaire is run every three years or so to see if there are changes in the circumstances of the individual. Examples of such changes could be when a goal is met, when there is drastic increase or decrease in earnings or otherwise. We have seen the risk appetite increase as clients get older, and when their goals are met and, hence, have never followed the “100 minus your current age should be invested in growth assets” adage.

The author is the MD & CEO of International Money Matters.