The Hindu Business Line : Zooming in on risk appetite

Apart from factors such as attitude to risk and knowledge about financial investments, the risk appetite of an individual also varies according to an individual's life-stage. The major life-stages of an individual and the risks associated with them can be generalised as:

Young adult (high risk-appetite group): This age group covers individuals who are entering the workforce and beginning to acquire assets which often means falling into debt. The risks faced by this group are:

in the form of death where the individual usually does not have dependants to provide for;

disability, which can be as devastating as a disruption to income and the person may have to fall upon parental support, and

medical, as there are high chances of injuries from sporting and other such activities.

However, the time period available to recover from the losses is substantial and, in all probability, the individual can get back to a normal life-style after having absorbed those losses.

Young family (fairly high-risk appetite group): In this age group, both partners are often working and there is a high degree of debt. In the case of the death of either partner, loss of one income can be critical. In the event of disability, all family expenses continue, in addition to the medical expenses. Again, the time period is critical and plays a vital role in compensating the losses over a period.

Over forties (moderate risk appetite): By this stage, individual careers are well settled, debt reduced, children have completed schooling and are preparing for college. In this age bracket, health risks can start increasing as also that of death. For the same reasons, there could be an increase in medical expenses. In such situations, people are faced with lost income and high costs.

Middle age (low risk appetite): The concerns with regard to increasing risk of premature death, disablement and impairments continue. Moreover, the phase for settling the children has begun and this also calls for an increase in expenses. On the other hand, people may have substantial assets and other investments in place for retirement.

The pre-retiree/retiree (no risk, play-safe group): People are on the verge of retirement and looking to supplement their earnings. Retirement brings with it a change in lifestyle and a consequent reduction in expenses. The entire life earnings are best put in safe investments which assure fixed periodical returns. Along with monetary, people also look for emotional supplements.

Changes during the life-stages affect the risk appetite of an individual and, thus, require risk analysis and change in plan. A person may no longer have dependants dependant may no longer be there by way of a child starting a career or death of a parent.

A person may be switching jobs, leading to periods of unemployment or jobs with lower package. There can be cases of death of a working spouse.

Decisions based on risk appetite

Establishing one's own risk profile is an important part of the financial planning process. It has a bearing on how assets are to be allocated and the strategies can then be finalised accordingly to meet the financial goals.

Most people want to make money through investments without drawing up a financial plan and and evaluating their risk appetite.

Instead of thinking in terms of return alone, the investor can define how much risk he is prepared to accept and, thereby, afford to lose in any investment proposition.

Assessment has to be made in the context of whether the investor is risk-averse, risk-neutral or risk-friendly.

Risk Management

There are many ways in which risks can be handled. They are summarised as:

Control Measures

— risk avoidance (high frequency and high severity)

— risk reduction ( high frequency and low severity)

Financing measures

— risk retention (low frequency and low severity)

— risk transfer (low frequency and high severity)

Risk avoidance: It is possible to avoid certain type of risks altogether by not exposing oneself to them. However, it is rarely a big part of any risk-management programme as the trade-off of risk avoidance is that it usually requires giving up something.

Risk reduction: This refers to taking measures which are aimed at minimising the severity of losses when they occur. It can be a simple shift of valuables to the bank locker so that in case of theft or fire, the valuables are safe.

Risk retention: These are the types of risks that are generally retained as they occur with lower frequency and with a low severity. An example could be the risk of a punctured tyre while driving which does not result in devastating financial loss and, thus, we bear the cost in retaining the risk.

Risk transfer: The most appropriate way of handling risks that are associated with a low frequency and high severity is their transfer. Insurance is the most common method used for transferring risk as it shifts the risk from an individual to a group. Here, the cost of potential loss is large and, thus, retention is not a good alternative.

Risk is an essential ingredient of every investment. The expected return is a function of risk involved. One cannot avoid risks altogether but should learn to embrace and manage them to achieve the desired financial goals over a realistic time-frame.

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

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