Did You Know that the best and the highest returns occur when people anticipate suffering the greatest losses? This highlights what might happen when you take a risk- profit or loss. The Great Depression was the finest three year period for stock ownership ever. The three years beginning in 2009, during which the entire economy was  suffering losses, had the greatest single returns. Jesse Lauriston Livermore, who was a speculator in the stock  market, managed to make money off of the 1929 meltdown.

Before getting into discussing what risk appetite, risk capacity and risk tolerance really means, it is important to  first understand a little more about risk and its basics.

What Is Risk?

Risk is a general term for uncertainty. It is a chance at loss, or what you would call a risk of failure. Of course,  no investor wants to incur losses when they make an investment. However, there are certain situations when  risk cannot be avoided, leaving an investor exposed to the risk of incurring losses. So basically, Risk is an  uncertain event that if it occurs by any chance, it can have either a positive or negative impact on an investor’s  goals. The positive and negative impact being profit and loss.

Risk Appetite, Risk Capacity and Risk Tolerance

An investor’s financial decisions should be compatible with their risk profile. A risk profile is the degree of risk  that an investor is willing and able to take. A risk profile is important for determination of allocation of  investment assets for a portfolio. Businesses use a risk profile with the objective of reducing the potential risks.

The risk profile comprises three aspects – risk appetite, risk capacity and risk tolerance. To understand the distinction between each component, let us get into the root of each term.

Risk Capacity

Risk capacity is the highest amount of risk that an organisation can bear. The risk management process begins  with this phase. Risk management is the process of understanding and managing risks that may affect an  organisation’s ability to achieve its goals.

Also Read: Robo Advisory Platforms in Investment

For example, if an investor can only invest up to INR 2,00,000 in the stock market but is urged by a friend to  spend INR 3,00,000 on particular assets, he will be unable to do so since his risk capacity is just INR 2,00,000  and anything more is not feasible.

Time horizon, which is the timeframe over which an investor would continue to invest in a plan, helps in  determining the risk capacity of an investor. The size of an investor’s portfolio and risk profile also helps in  determining the risk capacity.

Risk Appetite

Risk appetite is the amount of risk an investor is willing to take in order to attain their predetermined financial  goals or objectives. For example, while everyone wants to go on a world tour, how many actually have the  required money to go on one? This example revolves around the economic concept of demand and buying  power. An investor with a higher risk appetite will be able to take higher risks and have the possibility of  earning higher returns. Likewise, an investor with a lower risk appetite will not be able to take higher risks,  reducing the likelihood of earning higher returns.

In order for an investor to determine its risk appetite, it is necessary to consider the probability of the risk and its  impact. Once that has been defined, the investor needs to examine and understand what they are going to do  within the risk appetite level that has been assigned to them. They need to align it with their long-term goals and  see if it is helping them reach their goals.

Risk appetite is different from risk capacity. Let’s take my previous example of an investor who can spend only  INR 2,00,000 in the stock market. Suppose he decides to diversify his stock portfolio. Now he won’t be  spending the entire INR 2,00,000 on one asset since he will need to split the amount into other assets as well.

Let us  assume that he wants to spend only INR 50,000 on one asset. Therefore, INR 50,000 will be the risk appetite the  investor is holding for a single asset. Another example would be to assume that the investor wants to go slow and play safe. Therefore, he decides that he doesn’t want to spend the entire INR 2,00,000 at once and wants to  spend only INR 25,000 first to see if it’s profitable or not. Then the amount of INR 25,000 will be his risk  appetite while INR 2,00,000 being his risk capacity.

Risk Tolerance

Risk tolerance is all about how much of a risk an investor is willing to tolerate. Here, the risk concerned is the  amount of loss an investor will have to bear when the stock market is experiencing large declines. Risk  tolerance can be measured by analysing an investor’s financial assets, time horizon, and need for income. It can

also be measured by analysing the risk capacity, risk appetite, and the investor’s willingness to sustain market  risk.

For example, suppose a passive investor who invested INR 2,000,000 in the stock market decides that if the  stock market falls and is projected to fall much more in the future, he would prefer to incur a loss of 15% and no  more. As a result, the moment he loses 15% of his money, he will sell his assets.