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.
Unfortunately, risk appetites cannot be quantified. Although expensive questionnaires with objective questions like “What will you do if the stock market crashes by 50%/” exist, they are easy to answer because the option “invest more and hold for the long term” seems like a clear choice, especially without real-life experience.
Then what does the risk appetite represent? It is a measure of how well we understand the following:
- Where we stand with our finances (A), where we need to go (B), and what we need to do about it (the path from A to B).
- What can go wrong in the path from A to B, and how well can we manage risk?
- 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 must take with a set of (different, relevant and personalised) questions.
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We believe that most investors are wrong about their risk “appetites” because they do not have sufficient risk awareness. As a result, in many cases, they either underestimate or overestimate the desired portfolio risk.
So, how can we become risk-aware? How can we identify our risk appetite before investing?
- Identify our future needs.
- Understand how inflation impacts these needs.
- How can we create a portfolio that overall (debt + equity) provides a return close to inflation after tax?
Most people, except those with extremely high incomes, must have 50-70% equity in their long-term portfolios. However, most individuals possess debt-laden portfolios and limited experience in the capital market, resulting in a significant disparity between the risks they should and can take. Someone with no equity experience should not immediately invest 50% or more of their available funds into equity.
Instead, investors should consider gradually investing in equity mutual funds (or stocks), beginning with 10% of their total monthly investment and slowly increasing this allocation over time. As experience grows, so does the ability to handle market fluctuations, and individuals can become more comfortable with the appropriate level of risk.
Determining risk appetite (becoming risk-aware) is an ongoing process. You can expect to know everything about risk and then start investing.
In contrast, some individuals, particularly senior citizens, may want to take on more risk than they can handle. Unlike younger do-it-yourself investors, they may not have the luxury of time, making professional advice valuable.
Those requiring professional advice can consult a SEBI-registered fee-only investment advisor from our curated list. Those wishing to DIY can use our Robo Advisory Tool.
To decide on the asset allocation, you will need to answer the following questions:
- When is the money required?
- Reasonable inflation and return expectations from equity and fixed income after tax.
- How much money can I invest?
- The above inputs will help you decide on the asset allocation. You can 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.
- 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.
- 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 know 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 few market cycles and consistent investing to get used to the volatility. In the meantime, investors should strive to become risk-aware. They should appreciate what is required to meet future expenses and remind themselves of this if their conviction wavers.