Risk Appetite vs Risk Tolerance: How They Should Impact Your Portfolio

Understanding Risk Appetite vs Risk Tolerance: Key to Portfolio Management

The landscape of portfolio allocation has evolved dramatically over the past few decades, incorporating not only a wider array of asset classes but also integrating considerations of risk tolerance. This evolution enterprise risk management, facilitated by the gamification of stock market apps and the democratizing influence of social media, has broadened investment access. While this inclusivity is a positive development, it introduces a new set of challenges, especially for those new to investing. The crux of these challenges lies in understanding one's risk appetite vs risk tolerance. Understanding how risk appetite defines and tolerance plays a pivotal role in defining an investor's capacity to endure financial uncertainty, shaping their asset selection accordingly.

Risk Management in Asset Selection: Navigating Market Dynamics Post-Covid

How should retail investors choose assets?

In the post-Covid era, the dynamics of the market have undergone significant shifts, impacting investors' risk appetite and their risk tolerance statements, for specific risks. The widespread belief in the unstoppable growth of virtually every asset class has recalibrated many investors' risk tolerance levels. This optimism, spurred by the meteoric rise of both speculative and traditional stocks, has led to a preference for high-risk, high-reward investments. However, this inclination poses a challenge, as it often results in a portfolio imbalance, with a heavier allocation towards volatile assets than what might be advisable based on one's actual risk tolerance.

Strategic Risk Management: Aligning Portfolio with True Risk Profile

Addressing the Misalignment of Risk Perception and Tolerance

The current investment climate underscores the importance of strategic risk management. Many investors, enticed by short-term gains, may overestimate their own risk exposure and tolerance. This misperception requires recalibration, demanding a deeper understanding of risk appetite vs risk tolerance, ensuring alignment with one's true risk capacity. It necessitates proper diversification, realistic goal setting, and preparation for market downturns. Through strategic planning and a candid assessment of risk appetite versus risk tolerance, investors can more effectively navigate the complexities of the modern market, ensuring their portfolio aligns with their long-term financial objectives and true risk capacity.

Risk Appetite Statement and Management: Ensuring Portfolio Balance

With some strategic planning and understanding of objectives, this can be avoided. Let's look at the management of your own risk.

This section emphasizes the importance of articulating a clear risk appetite statement and engaging in thorough risk management. By defining their risk parameters, particularly distinguishing between risk appetite and risk tolerance, and consistently applying them in investment decisions, individuals can maintain a balanced portfolio. This approach not only safeguards against the allure dangerous consequences of disproportionate risk-taking but also ensures that investment choices are in harmony with one's financial goals and an acceptable level of risk tolerance.

Risk Appetite

The first thing to consider is your appetite for risk, and this is quite a personal question. The first thing to ask yourself, is how comfortable are you with temporary falls in the value of your assets? Would a fall of 20% keep you up at night and cause you undue  concern? How about 30%? 40%? It is the regulation of assets in your portfolio that will dictate this, so it's something to note.

So what directs risk appetite?It's not something that a computer program can spit out, or you can reel off at will. It requires some thought, and perhaps some practice investing in a range of assets with smaller amounts. A large part of it is personality, but education also contributes - from your school days until the job role you fulfil now, and the business process you encounter day to day. Training and practice can affect this, but part of it will just be how you are.

The sooner you come to terms with this and get comfortable with it, the sooner you can continue to invest in your own style in relative peace. Do not mistake this for skill - it gets its own treatment, and for good reason.

Risk Tolerance

Understanding your risk tolerance is crucial. How much risk are you physically and emotionally prepared to take? How large is residual risk in your portfolio and how much do you need the cash in the short term? Do you have a family and a mortgage that need funding? Are you close to retirement? A young graduate will be able to bear much more risk, with 40y+ for their portfolio to recover, than someone close to retirement who will need to liquidate assets soon, or the head of a family who will need to pay for their child's education.

How much risk hungry you are for growth is a misleading statistic to explain risk tolerance, as are previous returns and what you think might be best. Simple qualitative research can help dictate where you fall on either of these higher risk tolerance or aversion scales, and there are an abundance of online questionnaires you can download to help you.

Once you've decided on risk framework and an asset pool you feel comfortable with, portfolio trackers like the Strabo dashboard will help you with measurement of individual risk and their performance, as well as industry standard risk management metrics. Even in recreation, you'll be able to keep an eye on your allocation and risk posture and know when to rebalance to stay in line with your preset risk management goals

Actions

So what does this mean someone looking at their portfolio today should do? The investing canon used to suggest an equity-bond split by age, where a 32 year old would have 32% bonds and the remaining 68% in equities, and so on up until retirement. This would change your risk profile as you moved through life, and thus had less risk exposure and less time to recover from the sporadic economic shocks that can result in longer term pullbacks.

However, a number of things are making this a little risk management and more dangerous consequences outdated. Firstly, bond markets are no longer providing the returns that they used to, and secondly people are living much longer, giving them lower risk tolerance and more time to recover from price dips.

Here at Strabo, we like to hold predominantly equity funds, with a small portion of the portfolio dedicated towards self-selected individual stocks and alternatives within the law like cryptocurrency and venture capital investments. Adopting this approach aligns with understanding and applying the concepts of risk appetite vs risk tolerance, enabling us to scratch the itch of self-selecting stocks, while leaving the majority of our portfolio to rumble along passively with the market. After all, more than 80% of even professional investors fail to beat the market.

Although favour has been with retail risk managers of late, the pendulum will soon swing back towards passive strategies as we eventually return to a bear market. In the august words of George RR Martin, Winter is Coming! This is similar advice to that you will hear from a seasoned industry practitioner.

So what?

With the risk appetite vs risk tolerance framework in mind, by all means, enjoy tech and crypto investments, but try to hold a strong exposure to the broader markets and economies. These will be back in favour once the current madness subsides, and will serve you well with no stress or decision paralysis. Pound or dollar cost average into these monthly, and you'll build yourself a good nest egg for retirement.

Specific percentages are hard to dictate given it's dependent on individual circumstances, risk tolerance limits, but for anyone in young to middle age, a vast 80–90%+ equity allocation, the majority of which is passive (or wholly if you lack experience, risk taking capacity or desire to manage risks and invest individually), is the most sensible options. Please do reach out with any questions, or simply to share your investing strategy! And whatever you do, don't forget to manage your allocation with Strabo!