What is risk appetite?

June 14, 2024
Financial Planning

Risk is about tolerating the potential for losses. Understanding your risk appetite allows you to make informed decisions about your money.

For some people, risk means excitement and opportunity. For others, it invokes feelings of fear and discomfort. We all experience a degree of risk in our everyday lives—whether simply walking down the street or investing in the share market. Everyone has a risk profile that defines their willingness to accept risk. It’s usually shaped by age, lifestyle, and goals and is likely to change over time.

Risk is about tolerating the potential for losses, the ability to withstand market movements and the inability to predict what’s ahead¹. In financial terms, risk is the chance that an outcome will differ from the expected outcome or return. It includes possibly losing some or all of your original investment². Often, you may not be aware of your risk appetite until you face a potential loss, so loss aversion becomes a significant factor when making decisions related to risk.

What is risk appetite and risk tolerance?

Risk appetite and risk tolerance are used interchangeably but are different.

Risk appetite is a broad description of the risk an investor is willing to accept to achieve their objectives. It’s a statement or series of statements that describe their attitude towards risk-taking .

Risk tolerance is the practical application of risk appetite³ and considers the degree of variability in returns an investor is willing to bear.

As an investor, you should understand your attitude towards risk. If you take on too much risk, you might panic and sell at the wrong time. But if you don’t expose yourself to enough risk, you may be disappointed with your returns and potentially unable to achieve your objectives.

How do I work out my risk appetite?

Think about how you might answer these questions:

How much money do I have to invest?
How much money am I willing to lose?
How worried would I be if share markets fell dramatically?
Am I planning to track your investments daily?
Would I consider investing in different types of investments?

Your age, income and investment objectives all help determine your risk appetite.

Age: generally, younger investors with a longer time horizon are more willing to take greater risks with their money to earn higher potential returns. Older investors with a shorter investment timeframe may be more cautious as they’ll need their money to be more readily available and have less time to recover from a loss.

Income: people who earn more and have a higher disposable income can typically afford to take more significant risks with their investments.

Investment objectives: be clear about why you’re investing, when you think you’ll need to withdraw your money, and how long you need the money to last. Saving for a holiday or a deposit on a home is quite different from investing for retirement.

Risk and Return

The relationship between risk and return underpins all financial decisions. The more risk an investor takes, the greater the potential return. However, investors expect to be compensated for this additional risk and should realise that taking on more risk doesn’t guarantee higher returns.

What type of investor are you?

High: willing to risk losing more money for better returns.
Moderate: willing to endure short-term loss for the prospect of better long-term growth opportunities.
Conservative: willing to accept lower returns for higher liquidity or stability.

Whatever your risk appetite, you should always consider risk and return before deciding what to do with your money. Although shares and property are generally considered higher-risk investments, even more conservative investments like bonds can experience short-term losses. No investment is entirely risk-free.

This explains why savvy investors typically have a diversified portfolio that includes several different types of investments.

Risk and Diversification

Don’t think that just because your friends invest in shares, you should, too. If you don’t have much to invest or want to access your money in a few years, shares may not be the correct type of investment for you.

Understanding your risk appetite and being honest about your goals will make you more comfortable with your investment decisions. A financial adviser can help you understand your risk appetite and create a suitable portfolio in alignment with your financial goals.

The simplest way to minimise investment risk is through diversification. A well-diversified portfolio will usually include different asset classes, like shares, property, bonds, and cash, with exposure across different industries, markets, and countries. The idea is to reduce the correlation between the various types of investments and have a good balance of assets moving in different directions and multiple times. If some of your assets perform poorly, others may perform well, offsetting the poor performers.

Although diversification doesn’t guarantee you won’t suffer a loss, it’s an effective way to minimise risk and help investors realise their financial goals.

Make informed decisions

You should monitor both your risk appetite and your investment portfolio over time.

Your risk appetite will likely change as you get older and your income or family situation changes.

Similarly, you should review your portfolio to ensure the risk level is still suited to your overall investment objectives. Financial markets are constantly changing, so the underlying assets you’re invested in could also change.

If you’re a confident investor, you should check that your portfolio is still on track to generate the level of return you want and, most importantly, at a comfortable level of risk. However, we encourage you to speak with a financial adviser, like the friendly team at Everalls Wealth Management . Our service offering includes regular reviews and suggestions to rebalance your portfolio as necessary.

By understanding your risk appetite, you’re better positioned to make well-informed and transparent financial decisions. It will help you identify opportunities to take on more risk where appropriate or see where you’re exposed to unnecessary risk and adjust accordingly. You’ll also avoid being caught up in the emotion of market activity, where panic can lead to a poorly timed and costly decision.

Source BT