Is your risk appetite actually what you believe it to be?

Rohit Mattoo

Imagine you’re on a road trip, cruising along with the windows down, feeling adventurous and free. You’ve taken the wheel, confident in your ability to navigate whatever comes your way. But then, the weather turns. The rain starts to pour, the fog rolls in, and the road becomes slippery. What once seemed like a thrilling journey now feels nerve-wracking. That’s when it hits you—your comfort with risk wasn’t as strong as you thought it was.

The same principle applies when it comes to investments as well. Many investors confidently categorise themselves as aggressive, moderate, or conservative risk takers but real-world volatility often test these assumptions. The ability to stomach market swings is very different in theory than in practice. This disconnect, where perceived risk appetite clashes with actual endurance, can lead to emotional decision-making—either panicking and pulling out too soon or taking on more risk than one can handle. Recognising this gap early and addressing it proactively can be the difference between wealth creation and wealth erosion. Conversely, some investors may underestimate their risk appetite, missing out on potential growth due to an overly conservative approach.

Understanding risk appetite and tolerance

Risk appetite refers to the level of risk an investor is willing to take based on financial goals, investment horizon, and personality. Risk tolerance, on the other hand, is how much risk an investor can realistically endure—both emotionally and financially—during market fluctuations. For instance, an investor may believe they are comfortable with high-risk equities, but if they panic and sell during a market dip, it reveals a lower actual tolerance than they initially assumed. This disconnect often results in emotional decision-making that derails financial plans.

Illusions about risk apetite

Several factors contribute to the gap between perceived and actual risk tolerance:

Market conditions: Bull markets create a false sense of confidence, while downturns trigger fear, leading investors to shift risk preferences impulsively.

Experience: First-time investors may think they can handle risk until they face their first market downturn, whereas seasoned investors develop a more realistic perspective.

Emotional biases: Loss aversion makes losses feel more painful than equivalent gains, and recency bias causes investors to react emotionally to short-term volatility. Herd mentality can also push investors into unsuitable risk-taking.

Life changes: A young professional may be comfortable with risk, but major life events like marriage, parenthood, or nearing retirement can alter priorities, shifting risk tolerance.

Time horizon perception: Investors often believe they have a long investment horizon, but when faced with short-term losses, they react as if their time frame is much shorter, leading to hasty decisions.

How to identify your real risk appetite

Understanding real risk tolerance requires self-reflection. Analyse past investment behaviour—did you remain invested during downturns or panic and exit? Reviewing such reactions offers insight into your actual comfort with risk. Risk profiling tools can help by factoring in income stability, investment horizon, and emotional response to volatility. Additionally, asset allocation choices often reveal hidden risk preferences—if a self-proclaimed aggressive investor leans heavily on fixed-income assets, they may be more conservative than they realise.

Investment horizons and financial goals also play a key role. Long-term investors can generally afford more risk than those needing short-term liquidity. A simple stress test—asking whether you could tolerate a 20% portfolio decline without making changes—can provide a reality check. Stress-testing portfolios under different market conditions helps determine if one can withstand volatility without making impulsive decisions.

Bridging the gap

Once investors recognise their true risk tolerance, aligning their portfolio becomes essential. A well-diversified mix of equities, fixed income, and alternative investments helps balance risk while meeting financial goals. Systematic Investment Plans (SIPs) can further ease volatility by spreading investments over time.  Since risk appetite evolves with life stages and market conditions, periodic portfolio reviews ensure alignment with actual tolerance. Regular rebalancing helps maintain an optimal risk-return profile, preventing the portfolio from drifting into an unintended risk category. Seeking professional advice can provide objective insights and tailored strategies for a sustainable approach.

Successful investing requires self-awareness. Misjudging risk appetite can lead to impulsive decisions that derail financial plans. Regular reassessment, disciplined investing, and a balanced strategy help investors stay on course. The goal isn’t just to invest but to do so in a way that is rational, resilient, and aligned with long-term financial well-being.

(The author is  National Head – Retail Sales, Axis Mutual Fund)