The importance of understanding your risk appetite before investing in Mutual Funds

How to determine your risk tolerance and choose the right mutual funds for you.

Many investors believe that their risk appetite can be neatly categorized into three buckets: low, medium, and high. They also assume that risk appetite is simply a measure of how much risk they can handle. However, both of these notions are incorrect.

Risk appetite is more complex than that. It is not just about how much risk you can handle, but also about how much risk you are willing to take. It is also about your time horizon and your financial goals.

In this article, we will explore the true meaning of risk appetite and how to determine your own risk tolerance. We will also discuss the importance of understanding your risk appetite before you start investing.

Investment risk appetite cannot be quantified. Although expensive questionnaires with objective questions like “What will you do if the stock market crashes by 50%” exist, they are easy to answer because the option “invest more and hold for the long term” seems like a clear choice, especially without real-life experience.

There are a few things you can do to determine your risk appetite:

Consider your financial situation: How much money do you have to invest? How much risk can you afford to take if your investments lose value?

Think about your investment goals: What are you hoping to achieve with your investments? Are you saving for retirement, a down payment on a house, or something else?

Reflect on your personality: Are you someone who is comfortable with uncertainty? Or do you prefer to play it safe?

Once you have a good understanding of your risk appetite, you can start to choose the right mutual funds for you. There are different types of mutual funds, each with different levels of risk. In the other words, risk appetite is not a measure of how much risk we can take. It is an appreciation of how much risk we should take.

Risk appetite = Risk awareness.

No one can measure how much risk we can take with a set of questions. We can measure our understanding of the risk we must take with a set of (different, relevant and personalised) questions.

So, how can we identify our risk appetite before investing in mutual funds or even a fixed deposit? In other words, how can we become risk-aware?

• Identify our future needs.
• Understand how inflation impacts these needs.
• How can we create a portfolio that overall (debt + equity) provides a return close to inflation after tax?

Most people, except those with extremely high incomes, must have 50-70 per cent equity in their long-term portfolios. However, most individuals possess debt-laden portfolios and limited experience in the capital market, resulting in a significant disparity between the risk they should and can take. Someone with no equity experience should not immediately invest 50 per cent or more of their available funds into equity.

Once you have a good understanding of your risk appetite, you can start to choose the right mutual funds for you. There are different types of mutual funds, each with different levels of risk.

Equity funds: Equity funds invest in stocks, which are considered to be riskier than other asset classes.

Bond funds: Bond funds invest in bonds, which are considered to be less risky than stocks.

Money market funds: Money market funds invest in short-term debt securities, which are considered to be the least risky type of mutual fund.

Instead, investors might consider gradually increasing their allocation to equities mutual funds (or stocks), starting with 10 per cent of their total monthly investment and progressively increasing it over time. The capacity to handle market volatility develops with experience, and individuals can become more comfortable with the proper degree of risk. Determining risk tolerance is a continuous process. In contrast, some individuals, particularly senior citizens, may want to take on more risk than they can handle. Unlike younger do-it-yourself investors, they may not have the luxury of time, making professional advice valuable.

To summarise, it is ideal if investors do not presume they know their risk tolerance or attempt to ascertain it through a quiz. Acclimating to capital market risk is a process that can be influenced by recency bias.

To get acclimated to the volatility, it would take several market cycles and regular investing. Meanwhile, investors should endeavour to become more risk-aware. That is, individuals should recognise what is needed to cover future expenditures and remind themselves of this whenever their conviction wavers.