Investment planning: Factors that determine investors’ risk appetite

Published: December 10, 2018 2:37 AM

A policy statement helps understand an investor’s risk appetite and determine financial goals accordingly

Construction of the policy statement requires two main inputs: Investment objectives and investment constraints.

By Rohan Chinchwadkar

Portfolio management has become challenging in recent times due to higher volatility in financial markets. The first step in constructing a well-designed investment portfolio is to create a policy statement. It is a roadmap in which investors articulate how much and what kind of risks they are willing to take, why they are investing and what constraints must be considered before investments are made. Since the needs, goals and constraints of investors change over time, it is important to periodically review the policy statement.

There are two key reasons for constructing a policy statement. First, it helps in designing a portfolio which is tailored to suit the personal financial situation of the investor. It achieves this by compelling the investor to articulate realistic investment goals. Second, it can be used to create an objective benchmark against which the performance of the portfolio and the portfolio manager can be evaluated.

Constructing portfolio
Construction of the policy statement requires two main inputs: Investment objectives and investment constraints. Investment objectives are essentially the goals of the investor expressed in terms of risk and return. If goals are expressed only in terms of return, portfolio managers might resort to high-risk investment strategies and create highly volatile portfolios which may lead to considerable losses. Thus, an analysis of the investor’s risk appetite should precede any discussion of return objectives.

An investor’s risk appetite determines not only which securities should be included in the portfolio, but also how capital should be allocated across different asset classes like equity and debt. A matrix released by T. Rowe Price, a publicly owned American investment firm with assets under management exceeding $700 billion, recommends different asset allocation strategies across stocks, bonds and cash based on the investor’s risk appetite and time horizon. Consider two investors, A and B, both with an investment time horizon of 3-5 years. A has a low risk appetite and B has a high risk appetite. T. Rowe Price matrix recommends that A should invest 100% of the capital in cash and B should invest 20% in cash, 40% in bonds and 40% in stocks.

So, what determines an investor’s risk appetite? A common view is that risk appetite depends on the investor’s personality and broad psychological makeup. While this is true, it is only a part of the story. Risk appetite also depends on a number of other factors like age, current income and expenses, family situation, insurance coverage, current net worth and future income expectations.

Older investors have fewer years left for generating income and hence usually have lower risk appetite as their priority is to preserve the value of their investments. Many would have also seen volatility in the market and appreciate the impact of risk on portfolio value. Older investors also have a shorter time horizon and hence the recommended allocation to equity usually reduces as age of the investor increases. The gap between current income and expenses also plays an important role in determining risk appetite. If an investor generates substantial excess income every month, it becomes possible to make investments which are riskier and require a longer time horizon to perform. Similarly, investors who have a high net worth and keep a sufficient cash reserve have a better cushion to protect them against emergencies and can make more aggressive investments.

Income and net worth
Apart from current income and net worth, future income expectations also influence risk appetite. An investor who is confident of generating an adequate and stable income for many years into the future doesn’t have to worry about the impact of short-term risk on portfolio value. Finally, an investor’s family situation is a critical factor driving risk appetite. Higher the number of dependents, lower is the ability to make risky bets. That being said, investors who purchase life, health and general insurance are able to protect themselves and their loved ones against various contingencies, thus increasing their ability to handle risker portfolios.

Based on these, there are tests to help investors determine their risk appetite. They divide investors into different risk categories like very conservative, conservative, moderate, aggressive and very aggressive. Depending on the results, portfolio managers suggest an initial allocation across asset classes and pick securities which satisfy investor’s risk preferences.

-The writer is assistant professor of Finance at IIM, Trichy

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