“No risk no gain!”, one of the most popular sayings in the investment world. This overly used saying also happens to be one of the most misinterpreted one. If you’ve ever went to an investment platform that markets robo-advisors and/or unit trust, you would most likely come across a filter that requires you to indicate your risk level. Common options include low risk, medium risk, high risk and very high risk. But what our financial blog believe they really should be asking is how tolerant you are to the risk of failure rather than as a blanket “risk profile” statement.
Risk Appetite in Investment
Risk Appetite follows the notion of No Risk No Gain. It appeals to people who are willing to take on failure for a much better potential upside return. When you ask someone about their risk appetite, generally people who are looking to get higher return would tell you that they have a bigger risk appetite.
Risk Tolerance in Investment
Risk Tolerance in Investment refers to the degree in which a negative change would cause an emotional response from an investor. It’s the ability to stomach swings and downturns as they happen without reacting excessively. People who have low risk tolerance tend to go for investment instruments that are relatively more stable.
Difference between Risk Appetite and Risk Tolerance in investment
While the difference between the two is minuscules, there is in fact a huge difference in terms of how we as humans behave based on our respective Risk Appetite and Risk Tolerance profile. It is for the same reason that many crypto and bitcoin investors who believed themselves to have high risk appetite, quiver and started selling during the recent crypto dip that saw bitcoin lost up to 30% of it’s value. Why is this so? Didn’t these people have a large risk appetite?
In short, Risk Appetite generally focuses on the upside of the investment. The very use of the term “appetite” causes our brain to imagine consuming; hence drawing the relationship in our mind between risk appetite and how much you are planning to achieve. Risk Tolerance on the other hand, focuses on primarily the downside of an investment. Risk tolerance focuses on how an individual handles the volatility of stock markets and its price movements. Somebody with higher risk tolerance often are not worried about price movements or sudden market dips.
Unfortunately thou, the misinterpretation and misuse of both terms comes when stocks and other investment instruments that have higher volatility has most of the time provided higher returns too. However, if you think about the reaction of how people react to market movements, you would realise that there is a distinct difference in terms of the way these 2 groups of people would act.
Using the recent 30% crypto dip again for example. Seeing a 30% dip in his portfolio for someone who has high risk appetite but low risk tolerance, would result in an action being taken. The gist of risk appetite comes from either winning/gaining or losing/making a loss. It’s a yes, no decision on whether your pick has gone up or it has gone down. Risk tolerance on the other hand, focuses on staying in the deep and being able to ride the bad times out. There are also plenty of startups and IPOs whose price do not fluctuate as much, but have an enormous growth and upside if the startup takes off.
So the next time you are planning your investment portfolio, learn to understand if you truly have large risk appetite