Investment 101: Understanding Risk Appetite

Conversations about investment often revolve around risk and returns. Some enthusiastic speakers would quote to you Iveta Cherneva, a best-selling author and political commentator, who is attributed to say, “Only those who play win. Only those who risk win. History favors risk-takers. It forgets the timid. Everything else is commentary.” One could take it out of context to get you to take unnecessary risks – especially with regards to your investment. Instead, it is best to recall the wise words of American economist Bernard Baruch: “Not even the ‘safest’ investment is without some risk and some element of speculation.”

‘Risk’ essentially refers to any uncertainty on your investment that may negatively impact your financial welfare. There are seven types of investment risks: market risk, credit risk, inflation risk, mortality risk, interest rate risk, liquidity risk, and inertia risk. Note that this list is not exhaustive. For instance, if your investment has foreign exposure (basically if you or your investment invests in another country), you may be exposed to country risk as well as currency risk.

To protect the interest of investors – especially retail or individual investors, regulators, personal finance consultants, investment advisors, and financial planners developed ways to measure an investor’s potential risk tolerance. That is why you may notice on some investment marketing materials it would indicate their risk level: high risk, medium risk, and low risk. Different investment assets would have their own extrapolation of these categories.

Let’s look at unit trust investments as one example. Unit trust funds are rated at different risk levels ranging from lower risk all the way to highest risk. Note that different institutions may use different levels to assess their funds risks. You may need to consult check with the respective fund houses or licenced financial advisor. If you are investing for the first time, the Securities Commission’s Guidelines on Sales Practices of Unlisted Capital Market Products stipulates that you will need to complete a suitability assessment test to objectively gauge your risk tolerance before you are allowed to pool your money in any fund. Your suitability assessment test results give your licensed financial advisor an idea of how much risk you can tolerate.

The next part of the equation is your risk appetite. The European Central Bank (ECB) defines ‘risk appetite’ as ‘the willingness of investors to bear financial risk with the expectation of generating a potential profit’. On an objective test, you may have a low-risk tolerance after factoring in your commitments, time horizons, and financial goals. However, you may be able to take on a bit more risk to receive greater returns. Conversely, you may have a higher risk tolerance based on the test; yet, you prefer to play it safe by investing in steady, certain notes. Ultimately, the decision to invest rests in your hands.

Understanding your risk appetite could also help you develop your portfolio better. Diversification is an exercise where you invest in various assets and asset classes rather than consolidating them in one type of portfolio. Understanding your risk appetite allows you or your financial advisor to develop a suitable portfolio distribution strategy.

Let’s say you have a low-risk appetite. Intuitively, you may think of sticking with Level 1 risk-level investments. This could include your government bonds, fixed deposits (FDs), high-yield savings account, money market fund, Amanah Saham Bumiputera or Amanah Saham Malaysia, or even your Employees Provident Fund (EPF) via voluntary contribution. You may even consider Funding Societies’ Guaranteed Investment Note (GIN). While Funding Societies’ products entail a higher risk compared to sovereign or bank investments, GIN investors can be assured that the investment is protected by a privately-backed capital guarantee and regular returns on investment. Your risk appetite could vary the distribution. You could consider having 80% of your portfolio composed of these low-risk investment assets with the remaining 20% in moderate-risk investment vehicles. Speaking to a licensed financial advisor could help you develop the right plan to achieve your financial goals.

To summarise, your risk appetite reflects how much risk you are personally willing to take on. It could vary from the risk tolerance assigned to you based on an objective evaluation. Guided by your risk appetite, you can filter out investments by their risk level for you to achieve your financial goals. Taking on risks isn’t a blind exercise; rather, you can make it a deliberate and informed decision-making process guided by both your internal factors and external considerations.