Risk appetite is the level of risk that an organization is prepared to accept in pursuit of its objectives, before action is deemed necessary to reduce the risk. It represents a balance between the potential benefits of innovation and the threats, that change inevitably brings. The ISO 31000 risk management standard refers to risk appetite as the “Amount and type of risk that an organization is prepared to pursue, retain or take”. This concept helps guide an organization’s approach to risk and risk management.
Averse: Avoidance of risk and uncertainty is a key organization objective.
Minimal: Preference for ultra-safe options that are low risk and only have a potential for limited reward.
Cautious: Preference for safe options that have a low degree of risk and may only have limited potential for reward.
Open: Willing to consider all potential options and choose the one most likely to result in successful delivery, while also providing an acceptable level of reward and value for money.
Hungry: Eager to be innovative and to choose options offering potentially higher business rewards, despite greater inherent risk.
Three main attributes determine your risk appetite: your personal attitude to risk, how much risk you need to take to achieve your investment goals, and your capacity for loss how much you can afford to lose.
“Understanding what risk to take when investing is a hard thing to do without guidance because taking on too little or too much risk can be dangerous,” says Charles Calkin, financial planner at James Hambro & Co.
Taking on too little investment risk means you may not achieve your financial goals, while taking on too much risk means you might lose money you can’t afford to lose.
Risk profiling is important for determining a proper investment and asset allocation for a portfolio. Every single person has a different risk profile as the risk appetite depends on psychological factors, loss bearing capacity, investor’s age, income & expenses and many such other things.
A risk profile is an evaluation of an individual’s willingness and ability to take risks. It can also refer to the threats to which an organization is exposed. A risk profile is important for determining a proper investment asset allocation for a portfolio. Organizations use a risk profile as a way to mitigate potential risks and threats.
Traditional finance uses the concepts of classical decision making, modern portfolio theory, and the capital asset pricing model (CAPM) to define the risk profile of an investor. In this model, investors are inherently risk averse and take on additional risk only if they judge those higher anticipated returns will compensate them for it. One of the fundamental results of modern portfolio theory is that, under the assumptions of the CAPM (Sharpe 1964), all investors invest in a combination of the risk-free asset and the market portfolio. The allocation of funds between the risk-free asset and the risky market portfolio is determined only by the risk aversion of the investor. Thus, in the world described by this traditional model, the investor’s risk profile is given by the risk aversion factor in the utility function of the investor.
Risk capacity applies to the objective ability of an investor to take on financial risk. Capacity depends on objective economic circumstances, such as the investor’s investment horizon, liquidity needs, income, and wealth, as well as tax rates and other factors. The primary distinguishing feature of risk capacity is that it is relatively immune to psychological distortion or subjective perception. Risk aversion, however, may be understood as the combination of psychological traits and emotional responses that determine the investor’s willingness to take on financial risk and the degree of psychological or emotional pain the investor experiences when faced with financial loss. These emotional factors are often even more important for practitioners to understand than the objective economic circumstances of the investor; yet, they are harder to measure.
Willing to take significant risks to maximise returns over the long term
*Possible Allocation – Equity: 90-100%; Debt and others: 0-10%
Seeking to maximise returns over medium to long term with high risk
*Possible Allocation – Equity: 70-90%; Debt and others: 10-30%
Looking for relatively higher returns over medium to long term with modest risk
*Possible Allocation: Equity: 40-60%; Debt and others: 40-60%
Willing to take small level of risk for potential returns over medium to long term
*Possible Allocation: Equity: 10-30%; Debt and others: 70-90%
Seeking safety of capital, minimal risk and minimum or low returns
* Possible Allocation: Equity: 0-10%; Debt and others: 90-100%