How can I identify my risk appetite before investing in mutual funds?

Published: October 12, 2021 at 8:26 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.

Do share if you found this useful

Use our Robo-advisory Excel Template for a start-to-finish financial plan! Now with a new demo video!  More than 640 investors and advisors use this!
Our flagship course! Learn to manage your portfolio like a pro to achieve your goals regardless of market conditions! More than 2525 investors and advisors are part of our exclusive Facebook Group! Get clarity on how to plan for your goals and achieve the necessary corpus no matter what the market condition is!! Watch the first lecture for free!  One-time payment! No recurring fees! Life-long access to videos in an exclusive Facebook Group! Reduce fear, uncertainty and doubt while investing! Learn how to plan for your goals before and after retirement with confidence.
Our new course!  Increase your income by getting people to pay for your skills! More than 585 salaried employees, entrepreneurs and financial advisors are part of our exclusive Facebook Group! Learn how to get people to pay for your skills! Whether you are a professional or small business owner who wants more clients via online visibility or a salaried person wanting a side income or passive income, we will show you how to achieve this by showcasing your skills and building a community that trusts you and pays you! (watch 1st lecture for free). One-time payment! No recurring fees! Life-long access to videos in an exclusive Facebook Group!   
My new book for kids: “Chinchu gets a superpower!” is now available!
Both boy and girl version covers of Chinchu gets a superpower
Both boy and girl version covers of Chinchu gets a superpower.
Most investor problems can be traced to a lack of informed decision making. We have all made bad decisions and money mistakes when we started earning and spent years undoing these mistakes. Why should our children go through the same pain? What is this book about? As parents, if we had to groom one ability in our children that is key not only to money management and investing but for any aspect of life, what would it be? My answer: Sound Decision Making. So in this book, we meet Chinchu, who is about to turn 10. What he wants for his birthday and how his parent’s plan for it and teach him several key ideas of decision making and money management is the narrative. What readers say!
Feedback from a young reader after reading Chinchu gets a Superpower (small version)
Feedback from a young reader after reading Chinchu gets a Superpower!
Must-read book even for adults! This is something that every parent should teach their kids right from their young age. The importance of money management and decision making based on their wants and needs. Very nicely written in simple terms. - Arun.
Buy the book: Chinchu gets a superpower for your child!
How to profit from content writing: Our new ebook for those interested in getting side income via content writing. It is available at a 50% discount for Rs. 500 only!
Did you know? We have more than 1000+ videos on YouTube to explore! Join our YouTube Community!

Want to check if the market is overvalued or undervalued? Use our market valuation tool (will work with any index!), or you buy the new Tactical Buy/Sell timing tool!
We publish mutual fund screeners and momentum, low volatility stock screeners .every month.
About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored three print books, You can be rich too with goal-based investing (CNBC TV18), Gamechanger, Chinchu Gets a Superpower! and seven other free e-books on various money management topics. He is a patron and co-founder of “Fee-only India,” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations based on money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association, IIST Alumni Association. For speaking engagements, write to pattu [at] freefincal [dot] com
About freefincal & its content policy Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. We do so without conflict of interest and bias. Follow us on Google News. Freefincal serves more than three million readers a year (5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication. Freefincal does not publish any paid articles, promotions, PR, satire or opinions without data. All opinions presented will only be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions, seek the correct answers, and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now. It is also available in Kindle format.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at a low cost! Get it or gift it to a young earner.

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is an in-depth dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step. Get the pdf for Rs 199 (instant download)
Free android apps