February 19, 2009

What is mean by Risk Appetite? What determines Risk-appetite?

Have you heard the word “Risk Apetite”?

You might have heard this word from your mutual funds agent, your Ulip agent, your stock broker, from analysts giving tips or any other place, we hear the word and then we feel we understand it. may be you understand it, But how do you define it?

risk appetite

One of the reader asked me to include this in my article and it seemed a good idea to me. Before writing this article, I had a good understanding and explanation of “What is Risk-appetite”? but instead of using my words I thought it would be a good idea to surf the net and try to find some material on it to help it write article. As expected, each one was totally correct, but not easy to understand by common public.

So at last I thought I should write it the way I see it and feel it. One of a simple funda I apply in my life is “if its complicated, its not worth”, So let me start this small explanation.

What is Risk appetite?

Risk appetite is the amount of risk you can take on your investment. It is the point till which you feel that you should be in the game because still in the long run you will be rewarded finally. Till that point there will not be enough change in your mental state.

The moment it reaches a point from where you feel like getting out is the best thing you can do, That is the point where you accept that you were wrong at the time of investment. that’s your Risk appetite point. Now this is for a situation where you can not decide in advance about your risk.

Lets see a Psychological aspect of this, When you see your money increase or decrease it has direct relationship with your emotional state. If your money keeps increasing, you will feel euphoria and get excited, you will be on top, and when you see it decrease or going down day by day. Our emotions guide us in our life, and they are very helpful in your financial life (to determine risk).

Lets see an example :

Ajay and Manish invested 100 in Share A, After some days the value dropper to 90, at this point both were calm, and accepted that this happened because of market volatility and its totally normal. After some more days price went down to 70. At this point Ajay thinks starts feeling oohh.. and oucch.. in his stomach.

This is the point where his emotional pain increases to a point where he can no longer stay with this investment. That’s the risk Appetite for Ajay. whereas Manish is not affected that much, still he can take loss of 20 more, only where prices drop to 50, he will feel jitters.

What determines the Risk-appetite?

Risk Appetite is determined from many factors like Your Expectations, Your current Situations and your past experiences.

Your Expectations

You risk appetite has to be proportional to your expectation. If you want more you Will have to take more risk.

In the above example, Ajay will exit the investment and take Rs.30 loss, but what if Shares drop to 60 and then starts moving up and up and finally reaches 130. Who will make profit. The person who had more risk-appetite.

Your Current Situations

Your current situations determine your risk appetite, If you are sound financially and can afford to loose more, you can have high risk appetite and vice versa. A person with a family to support will have less risk appetite than some one who is is totally independent and has all his salary to spend on his own.

Your Past Experience

Obviously, what happened in past with you in different situations will determine your future decisions. People who lost lot of money by investing in Jan 2008 will now have less risk-appetite, because next when they invest there money somewhere, they will get panicked easily by a small drop and hence may get out fast.

Where as a person who made great money in 2003-2007 bull markets will have high risk appetite.

I personally like Equity a lot, the reason may be because I want to make lots of money fast (expectations), I can afford to loose some money currently because of less responsibilities (current situations), and because I have made some (very small number) of quick profits (past experience).

What is good? High or Low Risk Appetite?

Its a personal thing, There is nothing like good or bad. Its a subjective matter. At last everything boils down to “You get what you wanted”, It must give you emotional satisfaction and joy.

There are people who are fine with 9% return per Annam and there are people who are not even satisfied with 20% returns.

What is Risk Factor of a Product?

Many people do not understand what is there risk appetite, I have friends who invested in Dec 2007 in ELSS funds, and cried a lot after it went down by 50%. The reason was they never understood the risk factors. I also saw my investments drop to same levels, but my mental state was not affected because I knew that it was possible with mutual funds and before investing I had accepted that if it happens, Its fine.

Risk and returns are always proportional. If A gives more returns than B, than A has to be more risky than B.

Generally people choose a product which matches there return expectation and then compromise with the risk and then later when there is loss more then there risk appetite, they cry.

The better thing would be to choose some thing which matches your risk-appetite on risk side and then accept that you deserve the returns provided by the product.

I know people who want more than 12% returns and also don’t want to see there investments see any negative returns ever. they are totally foolish to expect this. This will not happen.

Also I know people who are ready to see there investments dip by 30-40% with happiness but they only invest in PPF or bank FD’s, these people are bigger fool than former one;s, by not utilizing the equity power.

I hope you got all of your answers. If you still have any query feel free to ask us. You can leave your doubt in the comment section.

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Chetan Ambi
Chetan Ambi
11 years ago

Yes Manish.. This is the most important topic in the field of personal finance. Before investing in any product we must look at our risk appetite. Thanks for the very clear information…

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Manish Chauhan
Manish Chauhan
15 years ago

ohh ya .. it was a mistake while typing i guess .


15 years ago

Hi Manish,

I think u meant to say is risk and return are always directly prpotional. Higher the risk, higher the returns..