First step in achieving your investment goal: Understand ‘your risk appetite’

The equity market’s remarkable performance in 2023 underscored the importance of staying invested in the markets at all times, across funds, irrespective of their market cap. Markets may not always stay up but periods of declines should be seen as potential gateways to multiple opportunities. In addition, given the fact that India remains on a higher growth trajectory, a shift in India’s structural story and the government’s strong focus on manufacturing, the wheels are set in motion in the medium to longer term. Given this background, we strongly believe that if there is one lesson that investors across the spectrum will concur with, it is that ‘understanding risk appetite’ has a huge role to play in the investment journey.

Risk is often perceived in a negative connotation by investors. However, seasoned investors know that ‘risk’ and ‘rewards’ are two sides of the same coin. What is crucial is the ability to mitigate or manage ‘risk’. Simply put, risk management is a process of identifying, analysing, and mitigating uncertainty in investment decisions. Macro risk can broadly be classified into:

Systematic risk: This type of risk is caused by factors that are beyond the control of a specific company or individual and can cause severe damage to an investor’s portfolio. Multiple macroeconomic factors are at play here, resulting in changes in the expected returns of the entire market. Systematic risks are difficult to mitigate as only diversification may not solve the investor’s quandary. Some of the key systematic risks include market risk, interest rate risk, and inflation risk. Investors must consider prudent asset allocation and diversification of their assets to help mitigate some of these risks.

Unsystematic risk: Unsystematic risk is a result of factor(s) disrupting the normal functioning of an organisation. Situations like changes in government policies, rise in competition, change in consumer taste and preferences, development of substitute products, technological changes, etc can directly impact the performance of a company. Unlike the former, these can be mitigated by carefully diversifying the portfolio in quality assets and companies, depending on the investor’s investment horizon, corpus, and risk profile. Some of the types of unsystematic risk include business risk, credit risk, and reputation risk.

Understanding individual risk appetite

As investors, it is easy to fall prey to the surrounding noise without considering one’s own risk appetite. Simply put, an investor’s risk appetite is his/her ability to bear risk in a portfolio. Every investment involves some degree of risk that can be quantified in either absolute or relative terms. Fund managers measure risk through various fundamental and technical methods. Similarly, investors too can leverage ‘risk profilers’ to understand their individual risk appetites for a particular goal and plan their investment journey accordingly.

Most investors tend to believe that taking high risk will give them higher returns, but that may not always be the right perspective. You cannot expect returns without considering the potential risk parameters at hand. Therefore, risk is necessary and inseparable from the desirable performance. A solid understanding of risk in its different forms can help investors better understand the opportunities, trade-offs, and costs involved with different investment approaches.

From the investor’s perspective

It is not easy to chart out a plan to mitigate each type of risk as there are several external and internal factors at play here. However, understanding the risks involved and taking one’s risk appetite into consideration go a long way in mitigating them through hedging, correct asset allocation, and creation of a diversified portfolio. Further, risk-adjusted returns measure drawdowns as well to ensure that risk would be equal to the beta-adjusted returns.

(The author is the chief business officer of Axis Asset Management Company.)