Understanding Risk Appetite: A Guide to Asset Allocation for Investors

Last Updated on May 7, 2023 at 9:05 am

A viewer on our YouTube channel asks, “Sir, How can I identify my risk appetite. Please let me know the list of points to consider while deciding asset allocation. Thanks.” Many investors believe their risk appetite falls under three categories: low, medium and risk. They also assume risk appetite refers to “how much risk we can handle”. Both these notions are incorrect.

This question on investment risk appetite has a curious analogy to how students approach exams. One of the first things I tell my class when the semester opens is, marks are not a measure of your intelligence. They measure the effort and time management a student has put in to comply with the requirements of a system. No one can measure intelligence using marks. See: Do marks determine the future of our children? The system may not be perfect, but to earn the right to complain about the system, the student should comply with it as best he can.

Similarly, investment risk appetite is not a measure of how much risk we can take. No one can measure this! Sure there are fancy questionnaires available for a premium, but objective type question like “what will you do if the stock market crashes by 50%” are easy to answer because the option “invest more and hold for the long term” seems like the obvious choice especially when we have never faced such a situation in real life.  Please note: Such questionnaires are a regulatory requirement before a SEBI registered investment advisor can work with a client.

So what does the risk appetite represent? It is a measure of well we understand the following:

1. Where we stand wrt our finances (A) and where we need to go (B), and what we need to do about it (the path from A to B).
2. What can go wrong in the path from A to B, and how well can we manage risk?
3. What are the pros and cons of each investment product that we choose?

In other words, risk appetite is not a measure of how much risk we can take. It is an appreciation of how much risk we should take. Risk appetite = risk awareness.

No one can measure how much risk we can take with a set of questions. We can measure our understanding of the risk we need to take with a set of (different, relevant and personalised) questions.

So, how can we identify our risk appetite before investing in mutual funds or even a fixed deposit? In other words, how can we become risk-aware?

1. Identify our future needs.
2. Understand how inflation impacts these needs
3. How can we create a portfolio that overall (debt + equity) provides a return close to inflation after tax?

Most people (except those with a super high income) would require 50-70% of the equity in their long-term portfolios. Unfortunately, most people have debt-heavy portfolios and little experience in the capital market.

This means a huge gap between “risk they should take” and “risk they can take”. A person with no equity experience should not immediately invest 50% or more of what they can into equity.

Investors should ask themselves, “How can I gradually start investing in equity mutual funds (or stocks)?” They can start with 10% of their total monthly investment in equity mutual funds but should also gradually increase this allocation over the next few years.

With experience, our ability to stomach market ups and downs gradually increases, and we can become comfortable with “the risk that we should take”. Thus determining risk appetite is a regimen, a process.

In many cases, particularly for senior citizens, the opposite holds. Many wish to take on more risk than they can afford to. Unlike young DIY investors, they do not have much time on their hands, so professional advice is recommended. You can get started here to understand how you can become risk-aware: Basics of portfolio construction: A guide for beginners.

List of points to consider while deciding asset allocation:

1. When is the money required?
2. Reasonable inflation and return expectations from equity and fixed income after tax.
3. How much money can I invest?
4.  The above inputs will help you decide the asset allocation. Here is a step by step guide: Deciding on asset allocation for a financial goal. You can also use our Robo advisory tool to automatically determine the correct asset allocation for your goals and how to vary it in future to reduce risk.
5. If there is a difference between the money I can invest and the money I should invest (calculator output), how can we arrive at a compromise? This is a tough step, and not all DIYers would get it right. If you need help, consult a SEBI registered fee-only advisor from our list.
6. What is my current asset allocation? How long would it take to reach the desired allocation? What is my strategy to get there? Again a fee-only advisor can make a big difference here.

In summary, it is best if investors don’t assume they are aware of their risk appetite or try to determine it with a quiz. Getting used to capital market risk is a process and can be subject to recency bias.

It would take a couple of market cycles and consistent investing in getting used to the volatility. In the meantime, investors should strive to become risk-aware. That is, they should appreciate what is required for meeting future expenses and remind themselves of this if their conviction wavers.