Risk Appetite - Objective or Subjective

An interesting thought which came up the other day as I was travelling in the bus was one of exploring and understanding the concept of risk appetite, and what it actually meant for investors. One should understand that the concept of "risk" as we know it (and which is defined by fund managers and academics) is that of the volatility of an investment or asset class. Thus, the premise which is built upon this foundational concept will necessarily revolve around minimizing volatility within one's portfolio in order to "minimize risk". As I will be discussing in the paragraphs below, this is a flawed concept which may result in substantial losses for the average retail investor.

I think most readers would have experienced some form of "risk appetite assessment" at some point in their lives; whether it is during the financial evaluation being performed by a financial planner or perhaps an indepedent financial assessment being conducted by a fund manager to ascertain one's risk tolerance. In such cases, the term "propensity for risk" comes into play; and this essentially attempts to quantify and measure a person's tolerance for risk and for risky activities (a score or weight is attached to each response in a typical questionnaire). The term risky activities will relate to the asset class one wishes to invest in, as well as the returns reasonably expected from the person in relation to his return on investment (example, if you expect +/- 20% then you are considered "aggressive" and therefore likely to be able to take on more "risk"). Such questionnaire are inaccurate in at least 2 ways that I can think of:-

1) Each person's propensity for risk is a function of his own personality AND the current state of the economy and market. It is important to note that during the dot.com boom days, risk was defined as "not making more than your neighbour by day-trading stocks", while at the nadir of the market in 2003 risk was re-defined as "trying to prevent losing your pants due to the relentless fall in the stock market". The point I am trying to get across is that risk depends on how an individual feels about the health of the economy and the state of the stock market; and this is communicated through media reports and news articles. Right now, news reports mention manufacturing output dropping to its lowest level since 1983, and inflation hitting a 26-year high of 7.5% in April 2008. Thus, investors would probably be more risk-averse as they feel that the economy is teetering on the brink of recession, and it would be foolhardy to put money into equities when there is a chance of more downside. During boom times, irrational exuberance creeps in and causes one to take on more risk for the simple purpose of trying to beat the guy next door. Thus, I argue that one's propensity for risk is a subjective measure, not an objective one which can be measured using a questionnaire.

2) "Risk" as defined by value investors is the danger of losing your original capital, and I did mention in a previous post that capital preservation is a central tenet in investing. Thus, the proper and correct way to assess risk propensity would be to ask questions relating to preserving one's capital, and not base it upon the volatility of a particular portfolio. If one invests properly and with a margin of safety, then there is very little risk of losing money; volatility will NOT affect the returns from an investment if the underlying company's business is stable and growing. Academics get it all wrong when they equate volatility with risk.

Risky behaviour is basically investing in things we do not understand or have limited information about. In fact, when I casually survey my friends about their investments, a large number have not mch idea on the company they had bought, thus bringing me to the conclusion that they have engaged in risky behaviour. In such cases however, people may already be aware that they are speculating, but still insist on it for reasons other than rationality (something like playing the lottery when the chances of winning are amazingly remote!). So, I will leave this topic as part of my behavioural finance series under "Gambler's Fallacy".