It is clear that some people are more comfortable investing in risky stocks than others. In a similar vein, some firms carry significantly more operational risks and/or financial risks than their competitors. Therefore, the appetite for risk varies across both firms and individuals. But, what is risk appetite? Generally speaking, an individual’s or an organization’s risk appetite can be defined as the degree of risk they are comfortable taking.
For example, some investors might want to avoid small stocks due to their high return volatility. Or, some multinational firms might be comfortable with investing in emerging markets even though such markets are characterized by higher degrees of political risk, financial risk, etc. vis-à-vis developed markets.
Note that this is distinct from risk capacity, which is related to the maximum degree of risk an individual or business can accommodate.
In the rest of this lesson, we give more context to our risk appetite definition by elaborating on the distinction between risk appetite vs risk tolerance. You can also jump straight to a video summary.
Risk appetite vs risk tolerance
In the context of risk management, both risk appetite and risk tolerance serve to set limits to the amount or type of risk an organization is willing to bear. However, the difference between the two may not be crystal clear to beginners in this area.
Risk tolerance is all about the acceptable degree of variation around an organization’s target risk appetite. And, it is the responsibility of risk managers to set the appropriate thresholds.
There is an analogy to this in portfolio management. Imagine a mutual fund that has an objective to invest 60% of its funds in stocks and 40% in bonds. However, as prices change, the actual investment weights will start to stray away from the targeted investment weights. For example, suppose that the stock portion of the fund performs relatively well, such that stocks represent 65% of the fund value and bonds represent the remaining 35% of the fund value.
In such a scenario, what should the fund manager do? One option is to do nothing (especially if there is an expectation that the stocks will continue to do relatively well). The second option is to rebalance by selling a fraction of stocks owned and using the proceeds to purchase bonds so that the fund reverts to its target weights of 60% in stocks and 40% in bonds.
Let’s assume that according to the fund’s policy portfolio, which is an outcome of strategic asset allocation, deviations up to 10% from the target weights are permissible. This would mean that the fund manager would not be forced to rebalance until the weight of stocks reaches 70% and that he or she could choose to keep the current composition of 65% in stocks and 35% in bonds.
In this context, we can think of the fund’s objective of investing 60% in stocks and 40% in bonds as its risk appetite. And, the ±10% allowed variation from these target weights as the fund’s risk tolerance.
We started this post with a definition of risk appetite: the level of risk an individual or organization is comfortable with under normal circumstances. We explained that this differs from:
- The risk capacity, which deals with the maximum level of risk that can be borne, and,
- The risk tolerance, which sets the allowances around the ideal risk positions.
Aven (2013) “On the Meaning and Use of the Risk Appetite Concept” Risk Analysis, Vol. 33(3), pp. 462-468.
What is next?
Well done on completing this lesson, which is part of our course on investments.
- Next lesson: We introduce the concept of a fair game and explain how it is linked to the concept of risk appetite.
- Previous lesson: We devoted the previous lesson to the risk-free rate of return and the risk-free asset.
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