A comprehensive understanding of risk plays the most important in making investment decisions. However, the average the retail investor often does not know how to determine this. When a financial adviser asks an investor, what his or her risk appetite is, investors often instinctively say it is low. It is understandable why investors are risk averse. Nobody likes to lose money. That is why it is very important that investors and financial advisers understand the distinction between risk appetite and risk tolerance. Simply put, risk appetite is the investor’s willingness to take risk, whereas risk tolerance is the investor’s ability to take risk. Risk appetite depends on the investor’s age, experience and knowledge about investments, but it differs from person to person. A 25 year old professional with a good salary and no dependents may have low risk appetite, whereas a 65 year old retiree with a spouse and no mediclaim, but with a lot of investment experience may have a high risk appetite. When a financial adviser asks the investor, “How much risk are you willing to take?” the answer the adviser gets is the risk appetite of the investor. Therefore, in addition to enquiring about the investors risk appetite, it is important that financial advisers employ a structured objective approach to understand the risk tolerance of the investor. The investor with low risk appetite and high risk tolerance needs to understand, how much returns he or she is giving up for capital safety. On the other hand, an investor with high risk appetite and low risk tolerance needs to clearly understand the potential loss implications.
There are several methods to determine risk tolerance of an investor. Some of these are nothing more than thumb rules. It is important to note that, none of these methods on a standalone basis is a comprehensive measure of risk tolerance. Financial advisers should use a combination of some or ideally all of these methods, depending upon the situation, to gain a comprehensive understanding of the investors risk tolerance. Financial advisers should also aim to educate the investors, about their actual risk tolerance. Here are some of the methods used to evaluate risk tolerance.
The formula of Max Loss % is as follows:
Let us illustrate this with an example. Let us assume, the answer to question 1 is 5% and question 2 is 40%. In other words the investor can tolerate losing a maximum of 5% of his or her portfolio in one year, and the investor thinks that the stock market can go down by a maximum of 40% in one year. Let us further assume that the investor can get a risk free return of 9% (fixed deposit interest rate). The excel screenshot below illustrates, how to calculate the max loss %.
Therefore, in this method the maximum allocation to equity for this investor should be 29%. Higher the maximum percentage of the portfolio the investor can tolerate losing, higher is the equity allocation.
For each question, the risk model awards lower risk scores to the investor, who chooses the first or second option and higher risk scores to the investor, who chooses the third or fourth option. The criticism of the multiple choice question method is that is based on investor perception of risk. However, a properly designed questionnaire such as the one above enables a psychometric evaluation of the investor’s risk tolerance. Financial advisers can use the questionnaire method along with the other methods discussed above to understand the investor’s risk tolerance.
Conclusion
Risk return relationship is one the fundamental principles of finance. Therefore it is very important that investors do an objective evaluation of their risk tolerance before making investment decisions, instead of relying on perceptions. Investors or financial advisers can use a combination of the methods described above to determine the risk tolerance of the investor.
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