Risk Appetite Is Not Risk Capacity

If you have ever made an investment, chances are you have come across a risk appetite questionnaire. The questions are often vague and based on hypothetical probabilities that can be difficult for investors to assess. Nonetheless, the questionnaire ultimately labels your risk appetite as conservative, aggressive, or moderate. But that is only a measure of preference.

Should your personal preferences dictate logical decisions about your finances?

Let me illustrate this with a personal experience. In 2018, I decided to buy a flat in Mumbai. I did my own calculations and being an investment banker, I felt confident about what I was doing. I believed I had a high-risk appetite and would be able to take on the associated risks. It was not that simple.

As it turned out, my personal financial forecasts were wrong. I underestimated my expenses and had no buffer to absorb unexpected shocks. I paid dearly for those mistakes.

When the monthly EMIs on my housing loan began, I discovered that I could not afford them. I had to borrow money and ultimately move to Japan, where I earned a little more and could pay off my EMIs—none of which I had wanted to do.

So, what happened? I was simply acting on my risk appetite without properly calculating my actual risk capacity.

Ok, but what is risk capacity anyway?

You can think of risk capacity as a number based on your financial situation rather than your emotions. For example, a 30-year-old professional investing for retirement 30 years from now generally has a higher risk capacity than someone retiring in three years, because the younger investor has more time to recover from market downturns. Similarly, if you have substantial cash savings, you may be better able to absorb financial shocks.

This distinction becomes particularly important when markets are volatile. A risk questionnaire might classify you as an extremely aggressive investor, but could you truly absorb a 50% loss in your portfolio, as the questionnaire asks? Perhaps not. The questionnaire presents a hypothetical scenario; a real loss is different. Real-world risks can—and should—be forecasted.

If that is the case, why do so many institutions continue to rely on risk questionnaires?

Because they are extremely easy to administer. They need no calculations. To find your risk appetite, an adviser can simply consult a table—and that is it.

Calculating risk capacity, on the other hand, requires hard numbers. It requires an understanding of your financial history, your current circumstances, where your investments are held, your age, and other relevant factors. It involves extensive calculations—and few want to do that hard work.

Is risk appetite completely useless?

No! It matters at the point of investment.

Suppose you are trying to buy a house, but buying one is not particularly important to you at this stage. You might be willing to take slightly more risk, invest a smaller amount each month, and still work toward the goal. Alternatively, if buying a house is extremely important to you, you may choose a highly conservative approach and commit more money each month.

Does Qwark have a solution?

Yes! At Qwark, we examine your complete financial history, create forecasts, and conduct scenario analyses to calculate your risk capacity. The result is not a generic label such as aggressive, conservative, or neutral. It is an actual number that helps us recommend portfolios you can afford and sustain in the future.

Qwark allows you to make that choice in a disciplined way. Qwark is a goal-seeking investment adviser, and its portfolio recommendations are based on your risk capacity. However, you can choose a different portfolio that reflects your risk preference for a particular goal.

In short, Qwark does the hard calculations for you and recommends what it believes is right for your circumstances. However, you are always free to express your preferences. Those preferences are then linked to your specific goal.