Risk Appetite, Risk Capacity, And A Cricket Match

Risk appetite is how much risk an investor is ready / willing to take. On basis of his answer, we often mark him as an aggressive, moderate, or conservative investor. Based on only this criterion, if financial products are chosen – chances of going wrong is high. Why? Because such answers, given by investor, largely depends on – current market outlook, investor’s experience with some or other investment products, and finally, herd mentality that exists in that period. None of these are ideal or reliable ways to measure one’s risk profile. Even if we agree that investor is giving genuine, unbiased, and informed answers to risk profile questionnaire – still this may not lead to ideal and optimized investment decisions. What is the alternative then? The answer is – Risk Capacity.

Risk capacity of an investor is determined based on – individual financial net-worth, age, income level and above all the time horizon of the planned investment. Trusting risk capacity over risk appetite while finalizing on investment products – is often considered a better choice. Let us understand this with an example of cricket.

Example 1: Suppose, Team A, batting first, scored 199 runs in a 50 over match. Now, while Team B is coming to bat second – they can afford to not take any risk and keep a run rate of 4 per over should be sufficient. Here, even if Team B’s risk appetite is high, it makes sense to take a conservative or moderate approach to win the game (or achieve the goal).

Example 2: Suppose, Team A, batting first, scored 399 runs in a 50 over match. Now, while Team B is coming to bat second – they cannot afford to go slow as they must maintain a run rate of at least 8 per over. Here, even if Team B’s risk appetite is low, it makes sense to take an aggressive approach to win the game (or achieve the goal).

Relating this to personal finance, suppose a young investor of 30 years age (with not much of net-worth and surplus) is planning to achieve a long-term goal like retirement – choosing only low-yield fixed income assets for the same, will not be recommended – even if he is having a conservative risk appetite. Instead, he should take calculative exposure in well-managed equity assets as the goal is long-term and available surplus is not sufficient.

On the other hand, when the same young investor is planning to achieve a short-term goal like making a down-payment to purchase a house – choosing equity assets for the same will be a strict no-no. Instead, he should consider a non-volatile fixed-income instrument for the same.

The purpose of making investment may differ – going to an expensive vacation, foreclosing an outstanding loan, funding for children’s higher education or securing own retirement years etc. But while implementing any of these investment decisions – we must pick and choose some or other financial products. At this juncture knowing investor’s risk profile is said to be of paramount importance, which consists of his/her risk appetite and risk capacity. What is what? Let’s check. Read on.