Key Takeaways
Risk appetite vs risk tolerance: What are the key differences?
Risk appetite reflects an organization’s strategic willingness to take risks to achieve its long-term goals, whereas risk tolerance defines the operational limits or bearable amount of risk an organization can handle. Risk appetite is more static and strategic, while risk tolerance is dynamic and varies across departments or projects.
What are the practical applications and importance of implementing risk appetite and risk tolerance?
Understanding and implementing risk appetite and tolerance help organizations and individuals make well-informed, calculated decisions. These concepts enhance decision-making, risk communication within organizations, and alignment with stakeholders, ensuring practical and consistent outcomes.
How to use these strategies to enhance our day-to-day life decision-making?
Risk appetite helps us to figure out how much uncertainty we are willing to embrace to achieve our long-term goals(Changing career paths, or starting a new business). Risk tolerance, on the other hand, ‘normalizes’ such ambitions to align with reality. Risk tolerance ensures that the risks we are willing to take are within manageable limits. We can make well-balanced, calculated decisions by aligning these concepts with our own values.
Understanding risk appetite vs risk tolerance
We must first understand anything that needs to be used in practice!
Risk management is one of those areas where so many unusual terms float around and sometimes it can be hard to work your way around the nomenclature–as we all know, there are a number of diverging ideas and conceptions of risk and related concepts out there.
One topic that often comes up is the difference between risk appetite vs risk tolerance.
Are these two terms really the same? What do they actually mean? Let’s explore!
What is Risk Appetite?
Risk appetite is a term that describes the willingness to take on risky activities in pursuit of personal or collective values.
In other words, risk appetite is an indication of the level of risk that an organization, a business, or a person is willing to take in order to achieve their long-term objectives. This term oftentimes comes up in risk management through risk taking.
What does it mean to have a higher risk appetite?
It means that a particular organization is willing to prioritize high-risk activities in exchange for potentially gaining long-term benefits. An organization with a lower risk appetite, on the other hand, is willing to sacrifice some growth for more stability1Aven, Terje., 2013.
This is why, for an organization, having the knowledge of risk appetite and risk tolerance is extremely important. Because it provides an opportunity to logically gauge their values into action. Organizations, therefore use risk appetite as a guiding principle for goal setting, and decision making and to make sure that the risks they are taking are properly aligned with their long-term goals2Kaplan, Robert S., and Anette Mikes., 2012.
One of the real-world examples of risk appetite is how a startup tech company and a utility company would set their goals for a new venture. A startup company would set goals with a higher risk appetite because they have to risk a considerable amount of their resources in order to make a name for themselves. However, a utility company or a public service does not necessarily have to risk a lot of its resources because they are comparatively much more stable than a startup. So they would choose a safer option.
But it’s important to understand that, choosing a safer option is not necessarily a measure of ‘risk tolerance’.
What is Risk Tolerance?
In general terms, risk tolerance can be defined as the limit of risk an organization is willing to take, considering its long-term goals3Grable, John E., 2016.
In other words, risk tolerance is the bearable amount of risk that an organization can afford to take, in the broader realm of risk appetite4Kogan & Wallach, 1964. Risk tolerance is the inverse of risk aversion.
Therefore, organizations use risk tolerance to control and implement risk strategically. For instance, an organization would assign a set of several constraints for an upcoming project, based on their current financial situation and long-term goals. These constraints would be,
- A time constraint: a timeline, indicating the maximum number of months until the completion of the project.
- A financial constraint to keep the cash flow steady inside the organization
- A maximum allowable system shutdown time during the implementation of the project(an internet server or production lines)
- Constraints of engagement such as to what extent the information of the outcomes of the project should be shared to the public during the implementation.
These types of actions help the organization to remain in control of its finances while being able to absorb any potential future losses.
Risk appetite vs risk tolerance: key differences
Now that we understand both risk appetite and risk tolerance, let’s see how these two concepts are different from each other. Let’s take a simple example.
Imagine two hikers who are about to climb a mountain. The hiker who has a higher risk appetite would be willing to take the steep, rocky trail because it’s the fastest way to reach the summit, and the views of the summit are stunning. But it might be a dangerous and potentially harmful approach. The second hiker, who has a higher risk tolerance would take the much safer trail, sacrificing some of the beautiful views. It’s important to understand that both of these approaches to reaching the summit have their own merits. It’s just a matter of their individual values.
Here’s a summary of the key difference between risk appetite and risk tolerance:
Risk appetite has a strategic focus whereas risk tolerance has a more operational focus.
Organizations would make decisions, leaning towards a higher risk appetite because they see strategic advantages in the long run. However, the finishing touches of the original plan should always be made with a risk tolerance focus because as much as organizations seek a strategic edge, it has to be practically sound5Lam, J., 2017.
Flexibility
Say, a larger organization with several departments is going to start a new project. The risk appetite for that project would be common throughout all the departments. However, the amount of risk each department can afford to compensate for such a risk appetite would be vastly different from each other. This ‘amount of risk each department can afford‘ can be defined as, risk tolerance. In other words, risk appetite is often static whereas risk tolerance is oftentimes dynamic amongst different sectors of the same organization6McNeil, A. J., Frey, R., & Embrechts, P., 2015.
Alignment with outside investors and stakeholders
Strategic planning often takes place with collaborators, shareholders, and outside investors. Therefore risk appetite is always linked with outsiders. However, the risk tolerance reflects internal operational policies7Gontarek, Walter, and Ruth Bender., 2019.
The importance of understanding risk appetite vs risk tolerance
Now we see the differences between these two concepts, it’s crucial to understand why both of these concepts are important when making decisions, both as an organization or individually in day-to-day lives.
Risk appetite and risk tolerance enhance our day-to-day decision-making.
Taking risks’ is not something to be done without proper planning, no matter how small of a risk you are taking. Making ‘well-informed’ decisions would make our lives much easier, especially in the long run. By embracing and implementing these two concepts into our decision-making, we can ensure that we are making the most calculated decision8Taleb, N. N., 2012.
Improved risk communication
To reinforce the point made in the previous section, risk appetite can be static throughout the organization but the risk tolerance is not. By implementing these concepts, an organization can make sure that all the parts of the organization are on par with each other. It will help them to make well-calculated and consistent decisions9Power, M., 2007.
Regulatory compliance
International organizational standards, such as ISO 31000 require organizations require organizations to define and have a clear distinction between their risk appetite and tolerance. Organizations that put considerable effort into defining and revisiting these concepts that align with their long-term goals would be well positioned according to the risk management guidelines.
Conclusion
Understanding the differences between risk appetite and risk tolerance goes beyond just learning the definitions –these concepts will help you to balance your ambitions with practicality. Whether you’re starting a business or simply trying to decide to buy something on Amazon, recognizing your boundaries and ambitions ensures that every step you take is deliberate and meaningful. So, take the time to reflect on your risk appetite and tolerance—they’re your roadmap to informed, confident decision-making!
Further Readings
- Taleb, N. N. (2012). Antifragile: Things That Gain from Disorder. Random House
- Power, M. (2007). Organized Uncertainty: Designing a World of Risk Management. Oxford University Press
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