Does defining risk appetite really work?

As in every profession, financial planners, too, have their own jargon. To my mind, one of the more quixotic terms they use is ‘risk appetite’. I have not heard this term used very often in other contexts, for instance, in the case of a paraglider or a white water rafter, but it is commonly used while determining the asset allocation for otherwise staid clients. Of course, risk can take many forms, and financial risk is one of these. So, in that context, the term may not be misplaced. But what does it really mean?

While it implies the desire to take risk, I think it could be further synthesised into the ability to take risk and the willingness to do so. The problem is that there may be a disconnect between the two. Here are two examples:

• In case the stock market has had a stellar run over the past six months and you are planning the asset allocation for a client today, he/she will want you to overweight their equity allocation. They would be influenced by the recent performance of stocks and prone to extrapolate these gains into the future. In case you try to dissuade them in the light of their financial situation and the time line of their financial goals, they may not take kindly to it. Conversely, they may shy away from equity investing after a market correction. The reality that the risk of capital loss could be lower after the correction may be lost on them. This could be seen as a case of a person whose ability to take risk is limited but the desire is high.
   
• The opposite is the case of a middle-aged high net worth individual (HNI), who has greater ability to take risk (in the form of higher equity and alternative asset allocation), but may prefer to stick to fixed income assets due to certain bitter experiences incurred in the past. No amount of coaxing may help veer him around. For such investors, the risk of capital being eaten by inflation in the long term is not as scary as nominal losses that may occur in the short term.

Globally, this dichotomy has spawned an entire industry, which purports to help certified financial planners measure risk on objective parameters. Some techniques out of these may certainly be helpful to planners and clients. However, I think risk appetite assessment will remain a largely subjective rather than objective matter.

There will be instances when planners and clients will think in diametrically opposite manner. Unfortunately, no textbook contains a way to deal with this situation….