Risk Appetite

For a lot of investors, investing can be a pretty simple activity. It involves keeping oneself updated through numerous magazines, newspapers and news channels about the latest, most touted investment opportunities. The next step is obvious -- invest in these opportunities to the hilt in the hope of making some easy money. And if everything goes right, investors would have made a neat packet all because they were quick to seize upon these great investment opportunities.

We are sure the 'investment process' we have outlined will strike a chord with many an investor. We are not saying this is how all investors are investing, but it is a disturbingly familiar sight. As more and more newspapers, news channels, magazines, personal finance initiatives get launched, media hype around these so-called investment opportunities builds up even more rapidly, which in turn feeds investor interest. This escalates to a point where investors believe that since everyone is investing in the 'hot' investment opportunity, prudence demands that they adopt the same course of action, because not doing so will entail a great opportunity loss.

We could write an entire note on how this whole rigmarole is a prefect recipe for disaster and that investors should take the media hype with a bagful of salt. Over here we wish to highlight something critical that is overlooked by all three parties - the service provider that launches the investment opportunity, media that cannot seem to hype enough about it and the investor who is led to believe that it's the best thing to happen to him in a long time. And that small detail that is overlooked is the risk of investing in the 'hot opportunity'.

But how does the investor go about assessing his risk appetite? If an investor can afford to lose significant amount of money on his principal before it can generate a return, then his risk appetite is high. Put bluntly, risk is the amount of money that the investor can afford to lose, in the interim, in his quest for a certain return on his investment. If an investor can afford to lose only a moderate amount of money, then his risk appetite is on the lower side.

Our grouse with the media hype over a particular investment opportunity and investor enthusiasm for the same, is that rarely, if ever, is the risk of investing in the opportunity highlighted. It's always about how rewarding the opportunity can prove to be and never about how much the investor can stand to lose (i.e. risk) if the opportunity does not quite blossom like it's meant to. In other words, the investor gets half-baked, incomplete information. As a matter of fact, in the absence of information related to risk, information isn't just incomplete, it's downright misleading.

In our view, any discussion on an investment avenue is incomplete unless it underlines the risk along with the (probable) return on it. To that end, investors must pay as much attention to the risk of investing in an asset as the return on it. While it is difficult to quantify your appetite for risk, there are ways through which you can get a fairly good idea about how much risk you can take on in your quest for a return. We have highlighted some of the key points to keep in mind while evaluating your own risk appetite:

1) Risk can be loosely defined as the money you can afford to lose in the interim period until you achieve the return you have in mind. If you can afford to see significant erosion in your investments (say upto 50 per cent of investments) in order to achieve the target return then that makes you a high risk investor. If you are the type, who can tolerate a dip in your investments only upto a certain level (say upto 10 per cent), then you are low risk investor. While the fall in the investment value (10 per cent and 50 per cent) is only indicative, we are sure you get the drift.

2) Your choice of investments must flow from your risk. If you can take a 50 per cent drop in your investments then high risk investments like technology stocks/funds or aggressively managed funds like mid cap funds could suit your appetite. If you cannot tolerate too much volatility, then you must opt for lower risk investments like balanced funds (which invest about 65 per cent of assets in equities) for instance. The idea is to make your risk appetite and not the investment opportunity, as the reference point. Most investment disasters are fashioned when investors use the investment as a reference point and then try to mould their risk appetite accordingly.

3) The risk associated with an investment has a lot to do with the investment timing. One reason why a lot of investors burn their fingers (and portfolios) with the hot investment opportunities is not because the opportunity was a dud or because the media reported it all wrong; it's mainly because by the time they invested in the opportunity, it had already run its course and had peaked. In other words, it was a bubble waiting to burst. And since all good things must come to an end, the investment opportunity soon embarks on its (sharp) decline hurting investors who came in towards the end, the most. These investors either lose a lot of money or make so little of it that it's not worth the effort (and hype).
So the next time you hear/read of the next big opportunity in the media, ask yourself a simple question -- is it possible that since this hot opportunity is yesterday's news it has already run up more than it should and if I enter in it today I may either lose money or make very little money? A lot of investors, who if they had asked themselves this question, would not have been hurt in the hot investment opportunities of yore like technology/media stocks, mid caps, real estate and gold to cite a few.

4) Another strange aspect of risk is that it decreases with time. Certain market-linked investments like equities appear very risky prima facie. While this risk is clear and present, it's important to recognise that this risk is amplified over the short-term (less than 3 years). Over the long-term, the risk of investing in equities reduces. As a prominent fund manager observed equities are the riskiest asset over the short-term and the safest asset over the long-term. That is why where equities are concerned it pays to have a really long-term investment horizon.

5) Contrary to popular expert opinion, risk appetite for equities is not '100 minus the investor's age'. So if an investor is 30 years old, it does not necessarily imply that he must have 70 per cent of assets in equities (according to the 'formula' it does). Apart from the fact that this is skewed asset allocation, the investor may just not have the risk appetite for a 70 per cent equity allocation. He could be one of those investors who cannot tolerate more than a 10 per cent drop in his investments, in which case a 70 per cent equity investment is a clear invitation to disaster. On the same lines a 60-Yr old investor may have considerable appetite for equities and may want to invest more than the 40 per cent that the formula permits him.

6) The above point does not mean that there is absolutely no link between risk appetite and age. While it may not be true in every case, investor appetite for risk does decline with an increase in age. This is because

a) as investors age, they really can't tolerate sharp dips in their investments; it upsets them and makes them nervous. And

b) at an advanced age, investors are usually most concerned about planning for retirement. Since equities can be volatile over the short-term it is advisable to shift a majority of assets from equity to debt, as the investor approaches retirement age.

This article has been sourced from the July 2007 issue of Money Simplified -- The definitive guide to Financial Planning.

Tags: investment, risk appetite