June 28, 2022

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How Risk Appetite Can Shape Your Investment Portfolio

4 min read
investment Portfolio

If you’ve been researching investing and saving online, you will have probably bumped into a few paid online courses. Accessible via either a subscription or a one-off payment, you might be asked to pay between £7.99 and £200+ to unlock the secrets of the course. 

However, if the course is aimed at beginners, and is designed to provide insights into the core investing principles, then I’m happy to report that this knowledge is already freely available and I can share it with you in this and other articles. Let’s begin with a look at risk appetite.

Investing Tip: Invest according to your risk appetite, not your target return

Many investors have a clear idea of how much return they’d like to earn per year, or a target dividend yield, or a target portfolio value by a given date. 

This is the completely wrong way to start your investment plan. 

With higher risk, will come higher return. This is absolutely true in almost all cases – the free market and the laws that govern prices in an open market will ensure that any mis-pricing is swiftly corrected. So you can expect very few free lunches in this regard. 

Once you believe that the risk and reward relationship is fairly solid, you will realise that the real question you should be asking is not ‘how much return do I want’, but rather ‘how much risk do I want’. At the end of the day, as one of a million other market participants, we do not have the clout or economic power to set prices or demand returns. Instead, we may only choose to invest or not invest – at market rates of risk and return.

Therefore, the investing principle here is that your expected return will be closely linked to the maximum risk you are prepared to take (and not your personal preference of what return you would like to receive), so a detailed scrutiny of your personal risk tolerance is warranted. 

No Shame

To assess your risk tolerance, you could take an investing risk appetite questionnaire or consider times in your past where you have taken risks to evaluate how acceptable they felt. Risk tolerance is deeply subjective, and there is no right or wrong answer when it comes to where you should set the bar. 

A totally common, and very acceptable position for you to take would be to admit that actually, it would cause you a great deal of worry and stress to know that a substantial portion of your investment portfolio is at risk of significant losses in the case of market turmoil. In that case, your risk tolerance might be very low and you may even conclude that stocks and shares might never sit comfortably in your own investment portfolio

There’s no need to feel pressured or embarrassed about your risk tolerance – we all have a setting, and for some people it’s turned way up (10/10) and for others it sits lower down (1/10), or perhaps you do feel the heat from risk occasionally but you’re prepared to accept it in the hope of higher returns. 

How risk tolerance feeds into portfolio design

If your investment risk tolerance is high, then this affects your portfolio in two different ways. Firstly, you can allocate larger portions of your portfolio to riskier classes of assets. For example you may choose to allocate 80% of your portfolio to stocks and shares, with the remaining 20% in corporate bonds. 

Someone with a relatively low risk tolerance may decide that the opposite portfolio feels sensible to them: 80% in bonds and a smaller 20% in equities. This would still provide a higher expected return than bonds, giving some compensation for investing in equities, but this would be a much smaller premium than if the investor had opted for a larger weighting. 

The second way your risk tolerance should shape your investing approach is in what types of assets you buy within an asset class. Vietnamese small company shares and UK large company shares are both equities, but the UK shares will contain less risk and return owing to their size, level of diversification globally, and the stability of their home country. This is just one example that shows that within an asset class, there is actually a broad range of investment opportunities. So you will once again need to decide where on the spectrum from conservative to aggressive do you want to position your portfolio. 

Examples of riskier sub asset classes include:

  • Emerging markets equities
  • Individual physical properties
  • Investing in small businesses or start-ups

Some safer sub asset classes include:

  • Shares in diversified conglomerates
  • Government bonds

Building a portfolio is much like creating a meal from a list of raw ingredients. You will need to consult with your own risk profile to check whether each ingredient should be included, or not.

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