Question

Everyone is probably aware of the overall concept of risk and return. We are well aware of the "painful" side of risks present in our investments or 401k plans. However, we want to broaden our awareness that "risk" is not necessarily a bad word. In other words, we want to take a look at risk balance.

For your initial post discuss the concept of "no risk, no return" and its corollary "high risk, high return". How does risk appetite relate to these concepts?

Answer 1

Answer:

Returns are the gains or losses from a security in a particular period and are usually quoted as a percentage. Risk is the chance that an investment's actual return will be different than expected. Risk means that there is a possibility of losing some, or even all, of your original investment. Low levels of uncertainty (low risk) are associated with low potential returns. High levels of uncertainty (high risk) are associated with high potential returns. It’s crucial to keep in mind that higher risk does not guarantee higher return. The risk/return trade off only indicates that higher risk levels are associated with the possibility of higher returns, but nothing is guaranteed. At the same time, higher risk also means higher potential losses on an investment.

On the other hand, the risk-free return (considered as no risk taken) is represented by the return on U.S. Government Securities, as their chance of default is essentially zero. If funds are invested in any other securities other than government securities, it carries a higher risk. The degree of risk varies from one security to other security. While making investments calculated risks need to be taken for achieving a desired return. We should try to avoid the risk if it is evidently clear that we might lose our money like in case of investing in D rated client which is defaulting on all its payments since last one year. Necessary due diligence needs to be done before investing for identifying the risks involved. If the risk is within our risk appetite level then investment could be made for achieving the desired return.

Based on the risk appetite the individual need to decide how much risk can be taken. Risk appetite refers the acceptance of risk level. Every individual can decide the amount of risk he could take considering his/her income, net worth, cash flows and other factors. For example, individual X can take risk up to $1000 where individual Y can take risk up to $2000 considering their individual balance sheets and income stability. Risk appetite refers to the amount of risk an individual is willing to take for desired return. While making investments risk appetite is a primary factor to be considered prior to taking any decisions.