Risk Appetite and Risk ToleranceWe Compare the Two

Written By:
Lisa Borga

Reviewed By:
FundsNet Staff

Before undertaking any investment or project, it is crucial for individuals and businesses alike to determine the capacity for undertaking risk.

This is often expressed in terms of risk appetite and risk tolerance. However, these terms are often very poorly understood and, in some cases, used interchangeably.

Making the job of understanding and using these two concepts even more difficult is that it is easy to find a number of different definitions and misunderstandings when using these terms.

Despite this, risk appetite and risk tolerance are crucial concepts to understand in order to perform effective risk management and implement effective policies for determining when to undertake a given project or investment and when to pass.

In order to better help understand both of these concepts, we will explain each and compare them.

This way, you can better understand and integrate these concepts into your own risk management framework.

Risk Appetite Explained

Risk appetite describes the general level of risk that an individual or organization is willing to accept.

Risk is something that is always present in any undertaking, and it cannot be completely removed.

Instead, the risk simply must be managed in order to accept reasonable risks to achieve objectives while mitigating or avoiding unnecessary risks.

Risk appetite, thus, is the target level of risk that is viewed as acceptable.

Often this is determined as a targeted level of loss exposure that is viewed as acceptable within the bounds of the individual or organization’s objectives and resources.

This level will determine what risk type and amount of risk the individual or organization views as acceptable in the pursuit of its goals.

Often this will vary between given individuals and institutions based on a number of factors, including company culture, industry, competition, the financial resources available, and the specific objectives being pursued.

For example, if a considerable amount of financial resources are available to an individual investor, they may be less averse to a certain level of loss than an investor with fewer resources available.

Risk appetite is also not a stable value and instead will fluctuate regularly depending on circumstances, changing scenarios, resources, and the knowledge available.

It is important to regularly re-evaluate risk criteria at least annually and, in some cases, even daily to make appropriate adjustments to any targeted levels of risk.

Risk Tolerance

Now that you know that risk appetite refers to a targeted level of loss exposure, it is easier to understand what risk tolerance is.

At its most simple level, this can be described as the willingness to vary from a given level of risk appetite.

This makes sense because risk appetite essentially sets a broad standard for managing risk; however, in some cases, the importance of a particular project or investment may be much greater than others.

In this case, pursuing a particularly important objective may justify a higher risk that would ordinarily be rejected on the basis of risk appetite.

This means that whereas risk appetite is a broad strategy, risk tolerance is a much more tactical concept that applies to a particular objective.

This means that risk tolerance should be analyzed on a case-by-case basis to judge if a deviation from risk appetite is justified.

Comparing Risk Tolerance and Risk Appetite

Risk appetite and risk tolerance are highly related but distinct concepts.

An individual or organization should start their risk management strategy by determining their risk appetite, which is a general level of risk that they are willing to accept before accepting a given undertaking.

In contrast, risk tolerance is the level of risk that an individual or organization is willing to accept for an individual undertaking.

Essentially, this is the variance that one is willing to accept from the general standard set forth in their risk appetite. This means that risk appetite is less of a strategy and more of a case-by-case judgment regarding the risks and benefits of a specific initiative.

Perhaps the best way to understand the two concepts is with a simple analogy.

On most roadways, the world governments set speed limits that are thought to represent a general safe speed for travel and limit the risks associated with driving while allowing reasonably fast and effective travel.

Traveling past this speed will result in the risk of being ticketed by law enforcement.

This means that the speed limit can be thought of as the risk appetite for drivers on a given road or highway.

However, in most cases, drivers will not precisely follow the speed limit and will travel at speeds somewhat above or below the speed limit, and law enforcement can but rarely will take action to enforce speed exactly at the limit.

Every driver then has the choice to vary the speed limit each time they drive. However, the more they exceed the speed limit, the more likely they are to be ticketed.

Thus, the amount that any given driver is willing to exceed the speed limit can be thought of as their risk tolerance.

Conclusion

Both risk appetite and risk tolerance represent standards for the risk that an individual or organization is willing to accept and support conscious and informed decision-making regarding risks and benefits before undertaking a new project or investment.

Risk appetite is used to set a broad level of acceptable risk through which to consider new opportunities, and risk tolerance is an individual review through which to determine if an individual initiative justifies deviation from this broad standard for risk.

Both of these boundaries are equally useful, and they are both crucial tools for use in structuring and applying risk management principles.