Risk appetite, aversion and premium

Investors often hear of the maxim, ‘greater the risk, greater the reward’. Risk tolerance is the level of comfort with which a person takes risk. What exactly is this risk and how does it effect an investor’s decision?

An investor ‘S’ decides to buy stocks of a company. His friend had mentioned casually that the company was expected to do well. ‘S’ immediately placed an order readily lapping up risk on the little known stock. But ‘R’was cautious. What if the stock did not perform as well as predicted by some people? He was not going to rely on hearsay. He gathered information. ‘R’ was unsure if he should make the phone call and place the buy order.

S and R are two investors who are by nature extremely different. S is aggressive, while Ris not. The two have different levels of risk appetite. Their behavior is in line with their appetite to consume risk. Still other investors may altogether shy away from the markets at these turbulent times. The willingness of an investor to hold a risky asset varies.

Investors despise uncertainty. Risk appetite, risk aversion and risk premium is often used in place of the other. However, there are some finer nuances that distinguish one from the other. Some people take higher risks. In other words, they are willing to lose more until they get the expected returns. A person who can stand all his money getting eroded has a greater risk appetite. Risk appetite can be defined as the willingness of an investor to bear risk.

Risk-averse persons exhibit reluctance to accept a bargain with an uncertain payoff. He would instead be content with a deal that is more certain, but possibly with lower than anticipated returns. An investor is said to be risk-averse if he prefers less risk to more risk In between the two behaviors of risk aversion and risk seeking is a state called risk neutrality. One who is indifferent to risk is risk-neutral.

Risk premium is the return in excess of the risk-free rate of return that an investment is expected to yield. It can be construed as the reward for holding a risky investment rather than a risk-free one.

An investor’s appetite for risk decreases with age. A young unmarried investor may be quite aggressive. This is simply because he has not much financial commitment and has many more working years ahead of him. Even if he loses he can earn more.

On the other hand, an investor in his retirement years has to be more cautious. He cannot take high risk because he is dependent on the returns. He cannot afford to lose his investments. His need for money is far greater with inflation and day-to-day expenses. A middle-aged man will invest mostly in equity, while judiciously setting aside some funds for fixed instruments and retirement savings.

An investor must first understand his risk appetite. Once he comprehends it, he must invest in instruments accordingly. A high-risk investor has mostly equity instruments in his portfolio. A low-risk investor concentrates on fixed income sources. In the middle path are investors with medium-risk tolerance.

They can have a mix of equity and debt in their portfolio. Take for instance the balanced funds, offered by many fund houses. Aimed at such investors, they have a balanced mix of both high risk and low risk instruments.
Once an investor decides the extent of risk he will take then with the help of experts he may start building up a portfolio which has to be managed.
Conditions for portfolio management::
A portfolio manager (expert) advises his client on the management or administration of his investment portfolio. He may either be a discretionary or non-discretionary portfolio manager. A discretionary portfolio manager individually and independently manages the funds of each client in accordance with the needs of the client. A non-discretionary portfolio manager manages the funds according to the directions of the client.

An applicant for registration or renewal of registration as a portfolio manager is required to pay a non-refundable application fee of Rs 1 lakh. Every portfolio manager is required to pay a sum of Rs 10 lakhs as registration fee at the time of grant of certificate of registration by the SEBI.

The applicant has to be a body corporate and must have necessary infrastructure like adequate office space, equipment and the manpower to effectively discharge the activities of a portfolio manager. The principal officer of the applicant should have professional qualifications in finance, law, accountancy or business management from an institution recognised by the Government.

The applicant should have in its employment at least two persons who, between them, should have at least five years’ experience as portfolio managers, stock brokers or investment managers. The applicant has to fulfill the capital adequacy requirements, etc. The portfolio manager is required to have a minimum networth of Rs 50 lakhs. The certificate of registration by SEBI remains valid for three years.

The portfolio manager, before taking up an assignment of management of funds or portfolio of securities on behalf of the client, enters into an agreement in writing with the client, clearly defining the inter se relationship and setting out their mutual rights, liabilities and obligations.

The SEBI (Portfolio Managers) Regu-lations, 1993, have not prescribed any scale of fee to be charged by the portfolio managers. However, the regulations provide that the portfolio manager can charge a fee as per the agreement with the client for rendering portfolio management services. The fee so charged may be a fixed amount, a return-based fee or a combination of both. The portfolio manager should take specific prior permission from the client for charging such fees for each service rendered.

A portfolio manager is permitted to invest in derivatives, including transactions for hedging and portfolio rebalancing, through a recognised stock exchange. However, leveraging of portfolio is not permitted in respect of investment in derivatives.

The portfolio manager provides to the client the disclosure document at least two days prior to entering into an agreement with the client.

The disclosure document, inter alia, contains the quantum and manner of payment of fees payable by the client for each service rendered by the portfolio manager, portfolio risks, complete disclosures in respect of transactions with related parties as per the accounting standards specified by the Institute of Chartered Accountants of India in this regard, the performance of the portfolio manager and the audited financial statements of the portfolio manager for the immediately preceding three years.