The Hindu Business Line : Understanding risk appetite

Risk is the possibility of an adverse situation that each one of us faces daily in our lives. When we walk we may be hit by a vehicle, when we cook we might be injured in the kitchen, when we travel there is the possibility of an accident. If we invest money there is the possibility of the company going bankrupt. Thus, we may say that risk is the possibility of a loss, destruction or harm arising in the normal course of life. Risk in financial terms is considered as the level of volatility of the capital.

Non-Financial and Financial risk

Risk is synonymous with financial loss; however, there can be situations where the loss is non-financial — the loss of a beloved person or loss of school certificates and medals. Although these situations do not lead to a financial loss, they cause emotional anguish.

Risk, Pure and speculative

Pure risk describes situations that involve only the possibility of a loss or no loss; there is absolutely no chance of a gain. Let us say we own some valuable assets which could be either lost due to theft/natural disaster, etc., or remain with us resulting either in loss or no loss. On the other hand, speculative risk involves the possibility of a loss but also a chance of gain. Gambling is an example of a speculative risk where there are chances of a loss or gain.

What is risk appetite?

Risk appetite refers to the risk tolerance of the individual. If by nature one is conservative and averse to taking risks, selection of investment funds with lower risks, such as secured/balanced funds, may be appropriate. If one is enterprising and willing to take calculated risks, selection of funds with relatively high-risk exposure, such as growth funds, may be appropriate, thereby providing an opportunity for higher returns to the policyholder

People react differently to risk. While some may always be ready to accept it, others may not consider risk their cup of tea while still others may want to take positions between these two extreme ends. A person's risk appetite may fall in between the continuum of being very conservative to being very aggressive.

Attitude to risk

Risk and return go hand in hand. Higher the risk greater the return and vice-versa. People who are averse to risk are willing to accept investments with lower returns. On the other hand, people having a higher degree of risk appetite look at opportunities that can fetch them the maximum return rate, as their investments are riskier.

Every individual has a unique risk taking ability. The factors that affect ones risk tolerance levels are:

Age of a person.

Number of dependants, that is, liabilities at hand.

Knowledge about market, products, experience, investment terminology.

Time horizons, whether long or short term.

Assessment of financial concerns such as inflation, taxation, liquidity, income/growth

(To be continued)

(The author is CEO of Financial Planning Standards Board, India. The views are of the author and do not reflect the views of the organisation.)

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