Last week FE delved into understanding the term risk appetite, the corner stone of all financial planning. Having seen that this simple term is largely ambiguous in terms of a definition or mathematical calculation, we now touch upon the other softer issues, which play an equally important and decisive role in helping one understand their risk appetite.

We know that ones risk appetite depends on a person?s regular income, salary, dividends, interest earned, debts, loans, corpus and goals or objectives.

These can be fit into an equation, which gives us a somewhat clearer idea on how does one go about finding their risk appetite. However, other issues like a person?s psychological relationship with money, comforts, upbringing, family support, lifestyle, etc also determine their risk appetite.

Understanding these can go a long way in helping you decide how much risk you can really take, while planning ahead for your finances.

W-A-N-T

A rather simple method used by financial planners the world over to help understand people and their risk appetites better is the WANT model. This basically tries to understand a person?s willingness to take risks, ability to risks, need for the risk and time available. A combination of these factors can provide investors with a better insight on the extent of risk they can take. The willingness to take risks usually depends largely on a person?s background, upbringing and relationship with money since childhood. The ability on the other hand, is what financial planners try and calculate using methods like those discussed last week. The need is of course based solely on the person?s goal or requirement, and this keeps changing as one moves on in life. However, say you are investing ?X? amount today in the hope of it amounting to enough money to buy a house in 8 years, then the need or goal is the house and the time period is 8 years.

Risk and returns

It is a commonly believed theory that ones rewards are higher as their risk increases. However, this is not really the case, as one can take greater risk without gaining better returns, though this notion seems ridiculous to one now. On the other hand, the converse holds true, i.e. the higher the return one is after, the greater the risk they will have to take. All through the financial crisis, one common notion amongst all experts who had anything to say to investors, expressed was, ?There was complete lack of financial planning during the boom and people were almost completely invested in equity at one point. Greed had taken over and hence no one exited the market after making the returns they sought.?

Greed does play an important role too and happens to be many an investors? biggest downfall, especially when a financial cycle is at its peak. This is why in investing and financial planning, determining ones risk appetite and goal is important.

In fact, a person?s expectation with their current investment and the risk they need to take is usually inversely proportional. Hence, one realises that if they want more out of the corpus they are investing then they have to be willing to take greater risks.

Age

Lokesh Nathany, national head, wealth management, Almondz Global Securities, explained ?When one considers, as it is often done in India, that a person?s risk appetite is their investments in equity, then counting backwards from 100 is the thumb rule followed.?

This means that if a person is 30, then (100-30), 70% of their investments can be put in equity. Nathany explains, ?As age advances, a person reduces their investments in risky assets. This is as with age advancing one has fewer sources of regular income, especially post retirement, and therefore their investments are where one looks for steady returns. The exception is a really rich HNIs, whose requirement for their investing money reduces with age and hence the volatility of risky asset classes does not play a major role. We use a questionnaire to determine an investor?s risk appetite.?

Risk profiling questionnaires come in various shapes and sizes but most include certain common factors. The rationale for calculating risk appetite like this is simple ? if you have a big buffer to absorb unexpected losses then you can afford to take risks. So if you are a young, healthy, high-earning person with few dependents then you can make up for any losses in years to come. However, if you are old, of ill health and totally dependent on your investments to cover you and your dependents? living costs then there is very little margin for error.

The different factors influencing risk profile are usually given different weightings so that, for example, the age factor might contribute towards 35% of the final risk profile, whereas the acumen factor may only count for 8%. Once an investor has answered all of the questions in the risk profiler, the numbers are all added up and the resulting total will indicate where the investor fits on the investment spectrum.

A popular question that some financial planners like asking investors is, ?Are your current savings equal to five times or more than your annual income?? If the answer is yes, then the investor automatically falls into the category of highest risk taking ability, as they have a strong buffer. However, when one considers factors like retiring at the age of 65, inflation, ill health, etc, then the planners feel a person should aim to at least 15 times their annual salary as their retirement corpus. Five times is no longer considered as safe and financial planners would feel uneasy if that is the only corpus amount one has at retirement.

Family

While the family is the cornerstone of most decisions we make in our lives, it is also the biggest support system we all have and hence it plays a large role in understanding ones risk appetite. Say for example, Samir and Anil and are two 40-year-old bankers who now wish to invest a sum of Rs 20 lakh. Their goals are somewhat similar too, with both wishing to earn enough for their child?s marriage in 10 years and for their retirement. However, Anil stays in with his family of four where he is the sole bread earner, while Samir stays in a large joint family, where there are plenty of earning members in the family and there is a large support base. In this case, while planning ahead with their finances, Samir will find himself more comfortable taking higher risks and losses in a bid to achieved the desired returns, while Anil will have to play far more cautiously. Thus, in this instance, family was the important deciding factor in determining the risk appetite.

On the other hand, if Anil?s spouse is also earning and can make a sizable contribution to the family income, then his risk taking ability increases too and he may be able to invest more money in riskier asset classes and hopefully reap better returns, considering the long-term planning involved.

Thus, ones immediate support circle plays a big role in determining their risk appetite and ultimately how much of their wealth they can afford to lose in a bid to make the most of their investments.

Relationship with money

Gaurav Mashruwala, a certified financial planner tells us, ?Every person reacts to money differently. Their reaction and relationship with money depends largely on their growing up and the way they relate to money all their lives. For instance, one of my clients is really averse to equity and this is because equity has been considered a taboo in their family. Therefore his comfort level with this asset class is really low, and even though at times the investment in equity is necessary, its level has to always be maintained at a point where it does not emotionally worry or make the client too uneasy.?

On the other hand, many investors also keep changing their relationship as their experiences increase. Parag Parekh, founder of Parag Parekh Financial Services and an author and student of behavioural finance, had once mentioned, ?Before the IT bubble burst early in the new millennium, I had advised some of my clients to get out of this sector. However, at that point of time they all thought it was an absurd suggestion and preferred staying with the crowd. The same client of mine is now back and wants to invest his money in the equity markets, when most people are playing this asset class very slowly and cautiously.?

People have always reacted to money in different ways. We all see this in our everyday lives too, the class of investors who are already really rich, have a more ?stay rich and grow steady approach?, while those investors who are now earning well but need to use their investments to ?get rich? need to adopt a different financial plan all together and they have to take higher risks, even though their risk appetite may be mathematically lower. The WAR one can put, hence largely depends upon ones philosophy and relationship with money too. Some investors for instance who take a leap out of ?Rich Dad Poor Dad? or ?Buffetolgy? will find equities at low and volatile levels highly attractive even though the risk in the asset class is still high, while those investors who believe that now that they reached a certain stage in their financial freedom plan, find that they should just play it safe.

Similarly if a person has all their life believed in locking up their savings or putting it in a safe deposit box, and the biggest investments all their lives is a house and gold, as is the case with most Indians, then their risk appetite is considerably lower. This would be irrespective of a large buffer or corpus they may have. This is as comfort plays a very important role here, and this is once again based on the person?s relationship with money all their lives. If one notices, the generations prior to us have instilled the value of saving in our nation and the reluctance to take loans too. These have stood us in good stead. However, this conservative approach has also hampered our growth from reaching its potential. The next generations, especially those which have seen money and enjoyed its benefits all their lives, will by nature tend to be more risky in their investments and will be more at emotional ease to play in the equity markets or other volatile assets. Ironically, risk appetite is not just the amount one can afford to lose, as in that case a middle class investor has a lot less to lose yet is often more conservative than the richer investors who may stand to lose a lot.

Comfort level

?To the degree we’re not living our dreams, our comfort zone has more control of us than we have over ourselves,? said Peter McWilliams, a writer of best-selling self-help books.

Mashruwala feels ?Risk appetite is a word that cannot really be defined or calculated accurately. It is only a marketing gimmick used by sales agents to sell different products. In reality, the best a financial planner can do is to understand his/her client and prepare a portfolio in accordance to that. So many factors come into play, the way they relate to money, the way their spouses relate to money. For instance, if a husband and wife have come from different backgrounds and have different equations with money, the financial planning for that family will have to take into consideration both their individual relationships with money and accordingly come to an acceptable level of risk. The process gets complicated if tried to identify mathematically as is simply cannot be done. The best one can do is come to an acceptable level of wealth an investor is wiling to lose, in a bid to gamble on some riskier investments for higher returns, based on a multitude of factors.?

Parag Parekh, on the other hand, feels, ?The markets move due to multiple reasons, the main one being sentiments. People?s emotions and sentiments play a big role in the way they invest, therefore for any financial module or any market module to hold true is very difficult, as the biggest variable involved is people, who are temperamental by nature. So many investors and investments are based on the heart with or without any logical rationale to it and the bottomline is, trying to predict what comes next is only a game of chance, since the variables involved are too many.?

So the question arises that in a situation where everything is unpredictable and constantly changing, for someone to fix a portfolio, revisiting it and adjusting its allocation is as necessary as somehow finding an appropriate amount of WAR they can take, while planning ahead. Since the factors vary from numbers, facts, figures, to emotions, family, relationship with money, upbringing, etc, having a fix on the formulae is not possible. However, the key point for every individual in determining their WAR or risk appetite, which most people subconsciously feel, yet may chose to ignore, is comfort. The comfort level we have and feel at different loss levels. The factors that determine this comfort level has been discussed, however, pinning down, ?why one feels the way they do?? still leaves room for anomalies due to the word ?feel?. This allows A to hold on to his share when the price drops from Rs 100 to Rs 60 and B to exit when his Rs 100 share touches Rs 70.

They will each have their own reasons for doing so, and this is what determines their comfort zone and risk appetite. However, if B believes that the prices will rise and he requires the share price to touch Rs 130 for his objective to be met, he may hold the share even if it touches Rs 50. This is as he has to now step out of his comfort zone and take the added risk to fulfill the goal of his investment, in a bid to make the required returns. Risk appetite is a constantly changing number in our lives influenced by many factors and understanding this at all stages is essential in knowing why you are investing the way you are.