Risk appetite and asset allocation

The risk appetite of an investor is the single most important determinant of the allocation of funds across various asset classes. The different categories of assets classes have varying degrees of risks, while the level of risk appetite or risk tolerance of an individual depends on several factors. Some of the important factors that determine the risk-taking ability of an individual are the level of income, age of the investor, expectations of returns and the financial needs and liabilities.

It is a well-accepted fact that equities are among the riskiest of asset classes with the potential to generate highest returns over the long term as compared to all other asset classes. So those who not only have expectations of higher returns, but also have the stomach to digest potential losses can think of investing in equities. Investors who have very high level of income or who are young enough (in their 20s or 30s) can dare to take the risk of investing in equities as they can take the loss in their stride without losing their sleep. High income individuals can afford to lose money without any financial stress, while the young investors can bear the loss as they have enough working life to recoup their losses.

On the other hand, those with moderate expectations of returns and those who cannot take the loss of capital in their stride will go for investment in debt. Also, if an individual has plenty of financial liabilities to meet, his risk appetite will be quite low as he cannot afford to lose money lest he defaults on his financial commitments. So, equity is a strict no-no for him and his obvious choice will be debt. Apart from debt, gold and real estate are also assets that provide moderate returns with lower levels of risk, so investors with low risk appetite and moderate expectations of returns can invest in these assets for the long term.