In the previous chapter, we discussed the first step involved in the process of picking the right mutual fund. The purpose, expected return and the time frame within which we expect to achieve our financial goals are few aspects involved in the first leg of taking the financial journey. In this chapter, we will learn about the risk involved in this journey. We will explore what risk appetite is, how important this concept is for you and how you can develop a bearable risk appetite to get optimum returns from your mutual fund investments.
Remember Ranjit? Well, he called me today with a well defined set of goals. Now he doesn’t just want a vacation house in Goa, but also wants to retire at an early age of 45 and travel around the world. Now he is wondering about what should be the next step if one has redefined the goals to something bigger?
A bigger goal comes with an increased risk. Whenever you are thinking about reward or return on investment, the term ‘risk’ should always come into the picture. As we have discussed it in the previous modules, risk and reward are the two components of investment that work directly in proportion to one another. With increase in one, the other goes up as well, and vice versa.
Suppose Ranjit just had a goal of buying a new car, the possibility of achieving that target is much more likely and therefore, his appetite for accepting risk would be higher compared to that involved in the goal of buying a dream house. Do you agree?
Well, this brings us to the concept of ‘risk appetite.’ How much risk should you take in order to earn the expected return depends on the underlying financial goal. The tenure for achieving that goal also plays a crucial role in this.
So let’s go ahead and get into understanding risk appetite.
If one has to define risk appetite, it would go as – “the quantum of risk an individual or a company is ready to take to achieve its financial goal”. In simple terms, risk appetite means the amount you can afford to lose in order to gain the desired return.
In case of companies, ISO 31000 under the Risk Management Standards has been specifically designed to guide the organizations with methodized risk management practices for safeguarding their investments. Similarly, for individuals, it is equally important to have a defined risk appetite to safeguard from the stock market risks.
“I understand that risk is an unavoidable part of investing, but in what way does it serve my financial journey?”, asked Ranjit. Well, there are numerous benefits assessing one’s risk appetite. Here are some of them.
You will practically understand these aspects once you apply the skill of calculating risk and moulding it to work in your favour and optimize your portfolio.
As we saw, risk appetite is the amount you can afford to risk to earn the desired return from investment. It is in absolute terms. On the other hand, there is risk tolerance which is psychological preparedness to take the risk. Both these components together define an investor’s risk profile. The factors that affects risk appetite, risk tolerance and eventually risk profile, are:
This is not an exhaustive list of factors that affect risk taking capacity of an individual. There are many more that differ from person to person. It is a very subjective topic. How much money can one afford to lose totally depends upon their pocket size, right? But there are various risk profiles that can broadly be defined as follows:
The possibility of completely avoiding risk to earn rewards is out of the question as it goes hand in hand with the returns. So the perspective of considering risk as a favourable component in your investment plan isn’t wrong, is it? And if the risk is good for you, there has to be some parameters to confine and calculate it.
As Ranjit understood the importance of risk appetite and the role it plays in selecting the right mutual fund, he became more curious to learn how to analyze and develop risk appetite. Are you curious too? Here’s how.
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