Risk Appetite

Risk appetite can be defined as the total amount of risk an organisation or investor is willing to shoulder to obtain certain set objectives. It can also be described as an organisation’s capacity for risk or the maximum level of residual risk it can accept post the implementation of various risk management strategies. For investors, it is your risk-taking ability when investing in various market-linked instruments. In this article, we outline the meaning of risk appetite, factors that influence it, and how you can assess your own risk levels to make informed investment choices.

What is risk appetite?

Risk appetite means the amount of risk an investor is willing to accept in the pursuit of his financial objectives. It is the degree of risk you wish to shoulder when undertaking investments. In the context of organisations, risk appetite means the amount of risk an organisation is willing to take in order to achieve its strategic objectives. For organisations, risk appetite is directly related to the risk management philosophy that impacts its overall operating style, risk culture, and business decisions and strategies.

Understanding risk appetite with an Example

Risk appetite is defined as the maximum amount of risk you or an organisation is willing to take to fulfil your objectives before the potential for loss outweighs the attached benefits. A few examples can help you better understand the meaning of risk appetite. Suppose, the average return from a mutual fund scheme is 15%, but since it primarily invests in equity stocks of technology companies, the standard deviation is quite high at 7%. This means that the MF is subject to volatility and carries a high risk. If you choose to invest in the fund despite the high risks involved, you have a high risk appetite. In this case, you prefer to bet your funds on the expectation of high returns, despite the high levels of capital risk involved.

Alternatively, you have the option of investing in debt funds that offer average modest returns of 8% p.a. The chances of capital loss are low since the fund mainly invests in government bonds and securities. Let’s say we can quantify the risk at 10%. If you decide to opt for this investment despite its relatively low returns, you have a low risk appetite. This suggests that you value capital safety and steady returns over potentially substantial gains from riskier investments. It is important to note that your risk appetite guides your entire investment approach, not just the selection of one asset.

Factors that influence risk appetite

Understanding what is risk appetite is not enough, if you fail to understand the factors that affect it. The following factors influence the risk appetite of an organisation:

Industry and market conditions

The nature and pace of change within an industry can significantly impact the risk appetite of a company. Industries that are subject to rapid changes like the technology sector may require a higher risk appetite to drive innovation and keep pace with competitors. Therefore, the risk appetite of organisations vary depending on the industry and sector they belong to. Additionally, the risk appetite of a business can vary depending on the market outlook and economic climate, which includes elements like growth rates and inflation.

Market trends

Changing market trends can have a significant impact on the risk appetite of companies. For instance, businesses tend to become risk-averse during periods of market volatility and uncertainty. Conversely, businesses may be more willing to take on risk during periods of economic stability.

Regulatory requirements

Regulatory requirements have a significant bearing on the risk appetite of organisations. Restrictive compliance norms and regulatory frameworks can dictate the maximum risk an organisation can take. For instance, strict regulatory frameworks within the healthcare industry can limit the risk a business can take.

Organisational objective

Lastly, the company’s overall objective and mission play a crucial role in shaping its risk appetite. Businesses with an aggressive growth target may have a higher risk appetite than ones that are focused on steady returns and stability.

Classification of investors based on their risk appetite

In the context of investment, risk appetite is often used as a way to classify investors investing in mutual funds and other securities. Here’s how investors can be categorised on the basis of their varying risk appetites:

Conservative investor

Simply put, a conservative investor is a risk-averse investor who prefers to take minimum risks and adopt a highly cautious approach to investing. Conservative investors value capital protection more than high returns. Given their low risk appetites, these investors usually invest in fixed-income assets that offer stable returns and capital preservation. Generally, conservative investors in India invest in risk-free fixed deposits, government-backed schemes like PPF, and safe haven assets like gold.

Moderate investor

Moderate investors are those who are comfortable with risk, but do not wish to extend their risk exposure beyond a certain point. Such investors take on calculated risks to earn moderately high returns. A balanced investment approach is generally associated with moderate risk investors since they prefer parking some funds in low-risk assets and others in high-risk instruments. With a moderate approach, these investors can potentially earn better returns than conservative investors when markets rise while losing less than aggressive investors when markets fall.

Aggressive investor

High-risk investors who are willing to take on significant risks to earn high returns are classified as aggressive investors. These investors are willing to risk losing their original investment in the hopes of potentially high returns. In other words, aggressive investors value high returns over capital protection. These investors tend to invest in high-risk investment instruments that are prone to intense volatility like equity mutual funds, derivatives, or company shares. They seek to capitalise on volatility and earn high returns.

How to assess your risk appetite?

As an investor, you must evaluate your risk appetite diligently before making market-linked investments. Here are a few factors you can consider when defining what is your risk appetite:

The financial goals and objectives

Your risk appetite is intrinsically linked to your financial goals and objectives. Your financial goals can be anything from a short-term one like funding a vacation to long-term ones like financing your child’s education and retirement planning. Identifying your goals will help you ascertain how much risk you’re willing to take. Additionally, prioritising goals on the basis of delays and unavoidability helps. For instance, you can delay a vacation but not your child’s higher studies. This means you can take on more risk when investing for a goal where fulfilment can be delayed, but not for one that has a set deadline.

The tenure of your investment

The length of time you plan to hold the investment is a crucial component for analysing your risk appetite. Generally, if you have a long-term goal like retirement, you may be willing to take on riskier investments since you have more time to tackle market fluctuations. For short and medium-term goals, a cautious approach may be better.

Reaction to market movements

You should also consider your personal attitude towards risk and reactions to market volatility. For instance, if you are someone who can handle the intense upswings and downswings of the equity markets, you may have a high risk appetite. However, if you value financial security in general and panic during periods of market volatility, you may have a low to moderate risk appetite.

Risk appetite vs risk tolerance

While the terms ‘risk appetite’ and ‘risk tolerance’ are often used interchangeably, there are subtle differences between the two in terms of how each understands an individual’s outlook towards risk. Risk appetite means how much risk an individual investor or organisation is willing to take on to achieve its set objectives. In other words, it takes a proactive stance to risk taking. In other words, risk appetite means the maximum amount of residual risk you are willing to shoulder after the risk control and mitigation measures are implemented. Risk tolerance, on the other hand, measures the deviation from the risk appetite levels. It is the amount of variability in risk levels the organisation or investor is willing to accept to achieve a specific objective. Both risk appetite and risk tolerance work together to inform risk management decisions.

Conclusion

Companies devise risk appetite statements to identify their risk appetite relating to various types of risks. A risk appetite statement informs the organisation's decisions to realise its strategic goals, ensure efficient resource allocation, and effectively manage risks. As an investor, it is crucial to identify your risk appetite to make informed investment decisions. Determining how much loss you can handle for potentially significant gains is one of the first steps of formulating your investment strategy and approach. Assessing factors like your financial goals, investment horizon, general reaction to market fluctuations, and financial stability are key when determining your risk appetite. Whether you are a conservative investor or an aggressive one determines everything from asset selection to fund allocation and overall returns.

Once you have determined your risk appetite, you can start investing in mutual funds through the Bajaj Finserv Mutual Fund Platform. Here, you can browse through 1000+ mutual fund schemes, compare mutual funds, and curate a portfolio with funds that best match your risk exposure comfort and goals. Additionally, you can utilise our Mutual Fund Calculator to compute returns and see if the projected returns justifies the investment risk involved.