The very term ?risk appetite? seems like a simple enough and easy concept for most people to grasp. However, if one ponders on this much-used term for a couple of minutes, most of us would draw a blank. After all, what is one’s risk appetite, it has no definition and certainly no mathematical formulae, which will help one arrive at the number. Risk, as defined in the Oxford dictionary means, a situation involving exposure to danger or the possibility that something unpleasant will happen or a person or thing causing a risk or regarded in relation to risk. Now when one looks at the word appetite, which literally means hunger, and puts the two together, it either shows a slightly reckless side of human nature or a constant need for us to experience the rush of taking risks.

In the financial world, risk has a curious relationship with rewards. One usually believes that greater the risk greater the reward. Actually this statement is rather untrue. Risk is no doubt directly related to rewards. However, if one takes into consideration the goal, destination or ?reward? in the financial world, one may notice that there are many ways to get there. Some maybe more risky and some less risky, however the reward will not be any different. Say for example, if you are leading a group of soldiers across enemy lines on mission. You may spot many different routes to get there, some more risky and some less. In this case, just because you have taken a riskier route does not make the rewards any greater. It is in fact a foolish decision to make. Similarly, with risk and rewards, one must realise that for gaining a certain reward, taking a certain minimum risk is necessity and usually greater the reward one is after, greater the risk one has to take, and it is not the converse.

Goal-based

Since risk is highly difficult to calculate on a stand alone basis, one of the constants that one can try and set for themselves is their goals. So say if someone has an objective to buy a house in 10 years time and they have a corpus of Rs 10 lakh, they would have to invest a large portion of that in equities and other riskier asset classes, which can provide them with the returns that they would need to meet their goal. Also, being a long-term goal, one would expect equities as an asset class to be relatively easier to handle. Similarly, if one has Rs 30 lakh and one would like to buy a bigger house in 2 years, their investment has to be more focussed on debt, since the risk they can afford to take to meet their goal is lesser and for a short-term period debt is a safer asset class.

While these examples maybe very circumstantial and crude in nature, investors need to realise that so is the entire concept of ?risk appetite?. This method too may seem very impractical in today’s day and age where one dose not know what they will be doing 10 months from now, that 10 years may seem slightly far fetched. However, having a goal in mind for your investments, and taking the amount of risk required to achieve the goals, is one way for people to gauge what sort of risk they can, must and need to take.

How real is ?risk appetite??

Lokesh Nathany, national head wealth management, Almondz Global Securities feels ?Risk appetite is a person’s capacity to take a downside. That is the broad meaning and understanding of the term. Say if you have Rs 100, which you invest and that money becomes Rs 50.

Some people can take this loss and some people will not. In such circumstances some people with extremely low risk appetites will start panicking when their investment touches Rs 90 and will pull out. Others, with a high risk appetite may, even after their initial investment has come down to Rs 50 want to further invest. Risk appetite therefore determines a person’s capacity to bear a downside and hold on to the asset.?

As far as figuring out a persons risk appetite goes, Nathany felt, ?It is not easy to understand a person’s risk appetite and I do not know any mathematical way to calculate the same. We ask questions as part of a questionnaire we expect our clients to fill out, give weightage to each of these questions and use these to gauge a person’s risk appetite. Since there is no accurate figure one can give to risk appetite, we classify investors as conservative, risk takers, etc.?

While financial planners use various techniques to reach some understanding of a person’s risk appetite, the universal belief is that one can never accurately do so, since there is no number one will arrive at. This is in a way understandable for it is the financial planner who is supposed to, after understanding the client, suggest an investment plan, keeping the client’s risk-taking ability in mind. If we all knew how to do this ourselves, one would not really need a financial planner. However, the unfortunate thing is, in India and in most countries across the globe, there seems to be no real test or level of understanding a financial planner must reach before practicing.

The norms are broad and allow a lot of planners who may not really be suited to this position, to take it up. While ?risk appetite? may be the buzzword around the financial planning world, in reality it means different things for different people and none of the meanings are necessarily accurate.

Calculations, E=mc 2

?Mathematically risk is standard deviation. Therefore, at best one can calculate that with a certain portfolio. A person has x% chance of reaching his/her goals and (100-x) % chance of not reaching the goal. This is based on the risk one can calculate of every individual asset class. Once one calculates that, one can calculate an overall portfolio risk. However, this is a complicated system, which very few, if at all any, financial planners across the world use. Also, at the end of all this, a portfolio risk is still different from a persons individual risk,? says Gaurav Mashruwala, a certified financial planner.

Parag Parikh, founder and chairman of the Parag Parikh Financial Advisory Services Ltd explains, ?Simply put, if you as an investor have Rs 100, you may have the ability to take a loss of Rs 10. However, another investor who has Rs 20 to invest, may not be able to take that loss of Rs 10. Thus their risk appetites are different and depend on a large number of variables, most importantly their corpus to invest. Risk appetite also depends on an individual’s cash flow, net worth and his or her behaviour and emotional connect with money. It cannot be calculated mathematically, but it can roughly be arrived at, after one considers the various variables.?

The formula to calculate something like risk appetite is not yet known. This is basically as there are too many variables, factors and unknowns involved in the calculation, which are constantly subject to change. If one is to assume a person’s savings have amounted to Rs 7 lakh and they wish to invest the same, they can roughly calculate how much of their wealth they are the willing to put at risk. This is basically a person’s risk appetite.

One has to consider the person’s net worth, constant cash flow, emergency fund, regular expenses and debts while trying to find out how much the individual can afford to risk. Therefore, if the person has monthly expenses of Rs 30,000, and they would like to keep enough money aside to keep them afloat for one year at least in case of an emergency and loss of their regular income. Then, (30000*12) Rs 3,60,000 out of the Rs 7 lakh has to be invested somewhere safe and not so risky, like say for example a debt fund or fixed deposit. This leaves them with Rs 2,40,000. Out of this say, the person has dependents be it parents or kids, then they might wish to put aside another Rs 1 lakh for emergency situations like medical emergencies, into a liquid fund or bank account. This leaves the person with only Rs 1,40,000 left. Out of this, if they have any loan or debt on their head, which they still have to clear, like an auto loan, which has Rs 40,000 still to be paid, then that money may be put aside in a less risky investment. After all this, the person may feel the remaining Rs 1 lakh out of the Rs 7 lakh he/she has to invest, is the maximum amount they can afford to fully loose. Therefore, the wealth at risk (WAR) that they can afford to put is Rs 1 lakh, which can then be invested in any asset which promises great returns, be it a small cap company’s equities, a new mutual fund or a new venture all together.

The above method, while slightly accurate, far from covers the details one needs to consider to accurately arrive at a persons risk appetite. However, it does provide us with the best possible formulae for reaching the figure.

Assumptions

?I honestly feel the term risk appetite has no meaning to an individual and it is only their financial planners who can some what gauge this amount. There is no accurate number one can put to this, and this term is often misused or over used by people trying to sell riskier products, especially in the equity market. It is like when a patient visits a doctor, the doctor can ask you your symptoms and accordingly make the best diagnosis in his/her eyes. The doctor cannot ask the patient for the diagnosis. Similarly, a financial planner cannot ask a client what their risk appetite is, for if they knew, why would they need a planner. Risk appetite when calculated by a planner too may not be accurate for there is no fixed formulae to this and nor can asking a few questions on a questionnaire really help us understand a persons risk appetite,? explains Mashruwala.

Risk appetite is rightly a very vast topic to cover with such ease, and while people use this term loosely, few understand the true meaning of it. For a financial planner to calculate the same or for an investor, the process is going to be an accurate guess at best. In continuation of Mashurwala’s analogy between a financial planner and a doctor, a financial planner asking an investor what his risk appetite is, literally translates to a doctor asking a patient what is his pain threshold!

?If one sees risk as investments in equity or any other volatile asset class, then we consider their risk appetite to be 100 minus their age. This is the thumb rule followed, and simply means that as age advances, one should reduce their investments in risky investments. This is usually accurate since older people have a greater need for their investments to provide a regular income, while a younger working person is not so dependent on his investments. However, here too the situation varies from person to person, say in the case of an old, super high net worth individual, who has no real pressing need for the money he/she is investing, they may not mind the volatility of a riskier asset and hence still have a high risk appetite,? Nathany tells us.

Mashruwala also felt, ?In India people react differently towards equity. Most assume it is riskier and can also bring one fantastic returns and hence people punt on it often. However, if one looks at equity, the stock exchange and markets are heavily regulated right now and always under the scanner. This makes the risk very transparent. On the other hand, an asset class like debt, is relatively non-transparent and not always in the public eye and mind. People being the way they are cannot really stand, understand or take transparent risk and hence the minute things get bad, they run away from equity. The equity markets in India also see a constant churning of players who keep changing, with very few families having made lots of money over the years in the equity markets. In such an inexact and unpredictable scenario, as long as an investor and the planner can take a fair call on the portfolio risk in lieu of the goals, one is in safe hands. No profits can ever be guaranteed and the minute one is guaranteed a certain amount of profit by their planner or anyone else for that matter, they should be weary and on their guard.?

In India, a person’s risk appetite is usually assumed to be the amount of their portfolio the person invests in equities. Equities as an asset class cannot really be gauged for risk, a lesson the financial world has found out the hard way, for the past records are not big enough to accurately forecast a future. This brings one to the understanding that as far as equity investments go, the older and more established an industry, like say iron and steel for example, the easier is it to understand the risk and movements of the companies within the industry. However, conversely a relatively new industry like say IT is riskier to predict as one does not have enough of prior data to spot trends and outcomes for many situations.

Softer issues

Mashruwala also tells us that ?Every individual reacts to money differently. This is based on the way we have grown up and related to money all our lives. For some people all through their lives equities may have been a taboo, or for some people using money as a tool to make more money may be the most natural thing ever. Hence, for each person, money has a different meaning and importance.?

The softer issues involved in calculating different peoples risk appetites is probably the most critical and vast topic in this calculation. It covers a person’s relationship with money, his support circle, his emotions, temperaments and so many different variables, that quantifying them is virtually impossible. However, they each have different implications and exert a certain amount of influence on our risk appetite, either increasing or reducing it. A more indepth explanation for the same will be provided in the next FE investor edition, where one will hopefully come a little closer to understanding how much WAR can one handle.