Where to invest based on Risk Appetite?

So you think you are an aggressive investor. Right?

But will you be an aggressive investor in a rising as well as a falling market?

Maybe. Maybe not.

I know you are not sure. And don’t worry.

This is normal. We are humans.

As for our ability to assess risk + its impact on us, it fluctuates periodically. And that is something very important to understand. Our risk appetite can change over time. It can increase or decrease.

While making any investment, it is essential that you evaluate your risk appetite carefully. A smart investment strategy is the one that can help you gain sensibly obtainable profitable returns at that too with limited risk-taking. And there are several factors such as your age, income, liabilities, responsibilities, job stability, the field of work, types of financial goals you have, etc. that play a significant role in deciding your risk-taking behaviour

But you still need to acknowledge that your risk appetite isn’t constant. It can and will change based on recency bias and maybe a few more factors.

So if you are planning to invest, then you need to correctly assess your risk appetite and how it is prone to change even before you begin to look at where to invest money for your financial goals.

But that brings forth another angle.

Do you really understand risk appetite correctly? Or you are confusing it with something else?

Let’s try to understand a bit about risk.

Don’t worry. It will not be a boring discussion.

So…

Ask yourself. What is the perfect investment for you?

It’s easy.

Something that gives the safety of Fixed Deposits and returns of Equity!

Right? What else could you ask for?

But you also know that you can’t have everything. Neither in life nor investments. There are trade-offs and they have to be accepted. Period.

If you want to aim for higher than the risk-free rate of returns, then you will need to take risks. Its how the systems work.

Talking of risk, these days it’s quite normal to throw around terms like risk appetite, risk capacity and risk requirements in discussions of investments. And at first glance, all three look similar and interchangeable in regular vocabulary usage. But in reality, all 3 are very different dimensions of risk that make up your real Risk Profile – which is what should be used to decide your investment decisions. Not just your risk appetite, but the full risk profile which is made up of risk appetite, risk capacity and risk requirements.

What are these three actually? Lets’ briefly discuss them:

  • Risk Appetite – Very simple. Risk appetite is your willingness to take risks. And it deals with how comfortable you are with ups and downs of investments. It is like how fast you are willing to drive on a highway knowing the risks that come associated with the high-speed driving. When discussing risk, most people are talking precisely about their risk appetites.
  • Risk Capacity – This aspect is generally missed in normal discussions. Risk capacity is your actual ability to take risks based on current financial circumstances like income, expenses, liabilities, responsibilities, the criticality of your financial goals, time horizon for goals, etc.). Or in other words, how much risk you can afford to take.

Most people take the risk questionnaires which ask for responses and then, give some indication of an investor’s appetite to withstand losses. And mostly, these questionnaires are about people imagining and predicting(!) how they will react in a given situation. And that is where the problem lies.

As mentioned earlier too, people don’t realize is that their risk appetite is dynamic. In good markets, people overestimate their appetite for risk. But when markets fall, they forget what they said in good markets and seek comfort in conservative portfolios.

So since people have fluctuating risk appetites, it is very crucial to assess Risk Capacity as well as it focuses on investors’ actual (and not perceived or self-assessed) ability to withstand losses in their portfolio. And this is where a good investment advisor can bring in his intervention and help investors see the right things.

That was about the first two aspects of risk. But there is another angle. And that is about the Risk Requirement.

It is a more goal-specific aspect and depends on goal criticality, time available for goal, etc. Different goals have different risk requirements. For example, a short-term goal is not suitable to take risks with. While a long term goal can take comparatively higher risk to generate inflation-beating optimal returns.

Let see who people’s risk appetite changes for different situations:

  • If you are in the 20s with a stable income and no liabilities, then you may have a comparatively high-risk appetite. In such a scenario, your investment portfolio can be heavy on equity.
  • As you age and enter into 30-40s, your liabilities as well as your responsibilities will increase. Now your will be more goal-specific and inclined towards achieving financial goals such as buying a house on home loan, managing wedding expense, saving for children’s education, etc. Thus, as the risk appetite decreases for the shorter-term goals. The goals like retirement are still long term and hence, suitable for higher equity allocation (assuming your overall risk profile allows that).

How much equity and how much debt should be included in a portfolio is what proper asset allocation is all about.

You can use different mutual funds for different goals. Some goals like retirement are very long term goals suitable for high equity allocation. But since many people already have some debt part in retirement savings via EPF, VPF, PPF and NPS, even those can and should be included in Goal-based Financial Planning. Another option that allows some in-built asset allocation control that many investors want from a single product itself is Unit-Linked Insurance Plans (ULIPs). I am sure you already know what ULIPs are. Offered by insurance companies these are hybrid products offering both insurance and investments. A small portion of the premium goes towards providing life insurance whereas the rest is invested as per chosen asset allocation and scheme choices. Ulips allow you to rebalance, switch from and to schemes in line with your risk appetite or goal requirement changes.

Since ULIPs are hybrid products and allow the investor to control asset allocation, the return on investment provided by ULIPs will depend on the chosen asset allocation. Under section 80(C) of the Income Tax Act, you can avail tax benefits on the investments made in ULIPs as well. So like PPF, EPF, ELSS, NPS, even the ULIPs can be treated as tax saving investments. However, you must note that this tax benefit is available only under the old income tax regime as the Budget 2020 introduced a new income tax regime (2020) that does not provide this tax benefit.

Coming back to our discussion of risk and how to invest based on it.

Now that you know that there are 3 dimensions of risk, you may wonder which of the three is most important. The importance of each may vary but the fact is, that you cannot ignore any of them. But having said that, I think risk capacity and risk requirement can lead the way, but within the reasonable bounds of risk appetite. Remember the risk appetite fluctuates so near-term bias in it can interfere with the correct long-term decision-making.

All investors are unique. Some have Low-Risk Tolerance. They don’t want to take any risks and live with bank FDs, PF, etc. On the other hand, some have a high-risk tolerance. They generally are open to taking more risk and have a high equity component (or other riskier products) as part of their portfolio. That was about those with high and low tolerances. But most people should be in the medium-risk tolerance mode. Of course, there is a risk of being wrong about risk tolerance as well.

But a good advisor can help you see that. How?

Ideally, your investments should keep adjusting as your risk profile changes. Experienced investors generally know how they fare on various risk parameters. But others might find it difficult.

If you are not sure about your risk profile or any aspect of it, it is strongly advised to talk to a good investment advisor. He will tell do a proper assessment of your risk profile and help create a focused investment strategy to help you reach your financial goals on your own terms. So please do not underestimate the importance of your risk appetite, risk capacity and risk requirement

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