“To stay healthy, you should always eat less than your full appetite.” – Unknown
Appetite refers to the quantum of hunger, Risk appetite is no different. Risk Appetite refers to how much risk you can have. Important that higher risk does not mean higher returns, it actually means higher probability of loss. In the recent bull run people, who have not seen the down turn yet do not fully grasp the meaning of risk. One of my known started investing in small caps based on his senior’s suggestion that with higher risk comes higher returns. his senior suggested that small caps are risky but produces higher returns, over last 5 years he garnered ~20% per year returns on his SIP. This prompted my known to put all his money in small caps, today on a YTD basis he is down ~30% and on SIP down ~18% annualized. He stopped his SIP and not do not want to touch small caps for foreseeable future. This is the impact of investing without understanding your own risk appetite. Our bikes are capable of top speed of 100+ but how many of us drive at 100+, i see some people never crossing 40-50 kmph speed limit, because while driving you go as fast as you are comfortable with. Same is true for investing, you should go as fast you are comfortable with.
In last write-up we talking about the risk capacity, approached it quantitatively as it can be measured (Read: 7 ratios to define risk capacity). Today we will talk about the qualitative measurement of the risk appetite, Overall risk profile should be a mix of risk appetite and risk capacity. If risk appetite is more than risk capacity, you should respect risk capacity and in vice versa, you should try to increase your risk appetite but acquiring new skills and making some changes in your plan. As risk appetite is qualitative measure, Let’s quickly go through the 5 main parameters & relevant questions to check our own approach. There is no right or wrong answers but just one answer which rhymes well as your first choice.
- Knowledge of financial shenanigans define, how well versed you are with terminologies and understanding the happening of financial markets and its impact on instruments. Terms like Interest rate parity, ROI, ROE, EBITDA, Sharpe ratio, Diversification, Beta, Volatility etc.
- (a) Understands all these terms
- (b) Knows some of them and can interpret
- (c) Know few terms but can not interpret
- Behavior in times of financial uncertainty defines our primary natural response, can you comprehend the difficult choices. What will your investment choice between the below options:
- (a) 10% chance of -20% return, 50% chance of 8% return and 40% chance of 16% return
- (b) 50% chance of 3% return and 50% chance of 13% return
- (c) 8% Assured return
- Behavior under stress when you see your money is just reducing day by day, how will you respond to that scenario. If you have invested INR 10 lacs and within a month it falls down by 10%, what will you do:
- (a) Buy more, as the investment is available at cheaper prices
- (b) Do nothing
- (c) Sell it, because you can not take risk to let it go further down and move it to assured return type of investment option
- Emotional stability in the time of distress is another important aspect. It shows, how much carefully you have planned your financials as well as what level of self confidence you have on those plans. If you have planned a foreign vacation which is quiet expensive and you were fired from your job just 7 days before that trip, what will you do?
- (a) Still go for the trip & Decide on the next steps
- (b) Go for the trip nervously and start applying for the jobs during the trip itself
- (c) Cancel the trip and start looking for the next job immediately
- Lastly, how do you rank yourself on the risk seeking behavior as no once can be a better judge of yours then you yourself.
- (a) Aggresive
- (b) Moderate
- (c) Risk Averse
Score yourself on the above questions; give 1 mark for a, 0.5 for b and 0 for c. If your total score is <2 then you are risk averse while >3.5 you are aggressive risk taker. You should use these parameters of risk appetite, risk capacity (Link), time to your financial goals and market valuation (Link) as parameters to define your equity asset allocation (Read: How much equity should you hold?).